When it comes to markets and investments, it’s easy to focus on the upside. Lists of the top-performing sectors, funds and individual stocks feature prominently in financial media each year. It’s fun to focus on winners. Much less attention is paid to the equally important elements of volatility and downside risk.
Volatile periods can be unnerving for investors. They can result in emotional distress and may lead investors to succumb to decision-reversal risk, potentially abandoning their chosen investment program at precisely the wrong time — that is, at the point of maximum loss. But losses hurt mathematically as well as psychologically: They can have a serious negative effect on an investment’s long-term growth due to an effect known as “volatility drag.”
Consider a hypothetical $100,000 investment that loses 20%. To recoup the loss, the investment must gain 25%. Deepen the loss to 50%, and the gain to recoup the loss grows to 100%. The rebound gain necessary to recoup losses grows exponentially from there, as illustrated below.