Risk
Volatility drag
Also called Variance drain
The way volatility reduces compounded returns below the simple average of the yearly returns.
How it works
Because gains and losses compound multiplicatively, a series of volatile returns compounds to less than its own arithmetic average. The more volatile the path, the wider the gap.
This is why the geometric mean — the CAGR — is always at or below the arithmetic mean, and why smoother paths with the same average return end up richer.
Where it misleads people
This is the mechanism that makes daily-rebalanced leveraged funds unsuitable for long holding periods. The drag scales with the square of leverage.
Worked example
Up 50% then down 50% averages 0% arithmetically and leaves you with 75 cents on the dollar. Two years, no average gain, a 25% loss.
Related terms
- CAGRThe steady yearly rate that would have turned your starting value into your ending value.
- VolatilityHow much an investment’s returns bounce around their average — the standard measure of risk.
- Leveraged ETFA fund designed to deliver a multiple of an index’s return, reset every single day.
- LeverageUsing borrowed money to increase exposure beyond what your own capital would buy.
- CompoundingEarning returns on the returns you already earned, so growth accelerates the longer you leave it alone.
More in Risk
Educational reference only. Nothing here is investment advice or a recommendation to buy or sell anything, and tax treatment depends on your own circumstances and the country you are in.