Volatility Drag

Volatility drag refers to the difference between arithmetic and compound investment returns.  Compound mean returns are always less than or equal to arithmetic mean returns (see the definition for geometric mean maximization for more on compound versus arithmetic returns).  Consider an example where an investor starts with $100 and experiences a 100 percent return year 1 and a 50 percent loss year 2.  The arithmetic mean return for this investor is 25 percent while the compound mean return is zero--the investor starts with $100, the $100 doubles to $200 after year 1, and then loses 50 percent or $100 year 2 to go back to where he started at $100.  Formally, the volatility drag is .5 times volatility squared.  As discussed in the geometric mean maximization definition, volatility is directly at odds with compound returns and therefore volatility can be seen as an impediment to compound wealth.  This is highly relevant to savers and investors who will need to live off of their compound wealth  during retirement.


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