A recent commentary in MarketWatch on the Technology Select Sector SPDR ETF’s gut-wrenching 80% drop during the tech crash of 2002 proved to be an excellent example of the effects of volatility on compounding.

Although the fund has finally surpassed its previous high water mark, it took 15 years for investors to get back to break-even. During that time, XLK, the ETF’s ticker symbol, had to quadruple in value to get back to its old high.

So goes the math of volatility and drawdowns. Consider two portfolios, both of which average 10% return over twenty years.  Portfolio I, which experienced 8% annual volatility, will have a cumulative return of 540%.  Portfolio II, which averaged 18% annual volatility, would have compounded at just 400%.   

This sort of dynamic should convince long-term investors that volatility – or rather, bets that volatility will continuously drop – is a dangerous wager.

The most obvious way to minimize volatility is, of course, diversification. But with interest rates on the rise, it is doubtful that fixed income will be as effective a counterbalance to equities that it has been in the past.

Another approach is to consider volatility as an asset class worthy of an allocation. There are several ways to profit when volatility increases, including managed futures and certain option strategies. Both are available in ETF and mutual fund form, and should be considered when looking for a way to reduce the long-term volatility of a client’s account. 

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Check out other Searching for Alpha commentaries by Ben Warwick.