Glossary
What is volatility drag?
Volatility drag is the gap between a portfolio's average annual return and what it actually compounds to. Because a loss requires a larger percentage gain to recover from, bumpier returns compound to less than smoother ones with the same average. The wider the swings, the bigger the gap.
Lose 50% and you need a 100% gain just to get back to where you started. That asymmetry is the whole mechanism.
A portfolio that gains 40% one year and loses 30% the next has averaged 5% a year. It has actually lost about 2%. The average is not wrong arithmetically — it is just not the number that describes your money.
This applies whether or not you are withdrawing, which is what separates it from sequence-of-returns risk. Volatility drag is about the size of the swings. Sequence risk is about their order.
Average return versus what compounds
| Steady portfolio | Volatile portfolio | |
|---|---|---|
| Average annual return | 9.0% | 9.5% |
| What it actually compounded to | 9.0% | 7.77% |
| Value after 20 years, no withdrawals | $5.60M | $4.47M |
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