At first glance, it might seem obvious one's portfolio goal is to maximize returns. In reality, the goal should be to maximize realized returns over the long-term. Realized returns are maximized by avoiding (or minimizing) taxes and fees. For this reason, most investors should favor index funds and trade infrequently. The long-term is defined as multiple market cycles (up and down markets). When it comes to maximizing long-term compounded growth, the key concept boils down to how one's portfolio manages bouts of volatility. This post will focus on the importance of minimizing volatility. Instead of discussing the academic versions of these ideas, let’s review a few hypothetical scenarios.
First, consider three portfolios A, B, and C from the above table. Each one alternates between a positive year and a negative year. In all three cases, the average return is a positive 2.5%, as the magnitude of the positive years is greater than the magnitude of the negative years. As an investor, which portfolio would you prefer? The average annual returns are the same, but the long-term realized returns are very different. As the nearby chart shows, the higher volatility of Portfolio C actually produces negative long-term results, because it takes more than a 35% gain to recover from a 30% loss. The moderate Portfolio B produces no gains for the same reason. The superiority of Portfolio A is not obvious in the annual data. It only becomes obvious after several market cycles. Portfolio A does a much better job limiting downside volatility, which serves the long-term investor well.
Next, consider these two portfolios. Portfolio A alternates between rising 100% and earning 0% return. Portfolio B earns 50% consistently. Again, both have the same average annual return. Which would you prefer?
Here again, the correct answer is to pick the portfolio with the lower volatility. Portfolio B actually has (an unrealistic) zero volatility and is thus superior, as shown by the Growth of $1 chart.
Lastly, just to use a more realistic return stream, consider these two portfolios.
In this case, there is a difference in the average annual returns. Portfolio A has higher average returns. Portfolio B has similar returns but lower volatility, and that is key.
The point for investors is to focus on volatility, especially downside volatility of their portfolios, not annual returns. That can be more difficult than it sounds, and a topic for another day.