I’m going to take you back to 3rd grade math class. You learned that 2 plus 2 minus 2 equals 4, and that it didn’t matter if you mixed up the order to 2 minus 2 plus 2, it still equaled 4. That’s true for Arithmetic returns, but not how portfolio returns work. Let me give you an example – as an investor, let’s say you start out with $100,000, experience a 20% decline to $80,000, then a 20% gain which would bring you back up to $96,000.

Arithmetic returns say negative 20% and then plus 20% get you back to zero. But that’s not how portfolio returns work. Down 20%, Plus 20%, your portfolio is still down, not even.

This concept can help you understand how a lower volatility may help you experience better returns.

These 3 portfolios all had the same arithmetic return over three years. That is, you add up the plusses and minuses and they are all 30%.

But that’s not how you experience returns on your statement, so let me show you how each of these supposedly equal portfolios would have looked on your statement.

This one is easy 10% per year for three years, one million grew to $1,331,000

Now we look at Portfolio B. This account also had a 30% arithmetic return over 3 years, and despite having a whooping 50% return in the year 3, the return you would have experienced as an investor is  $1,181,250. Not terrible, but almost $150,000 less than Portfolio A.

Last we look at Portfolio C. Once again this portfolio had a 30% arithmetic return over 3 years, and despite having back to back 20% years, the return you would have experienced as an investor is 1,296,000. Almost as much as portfolio A, but with less of the emotional roller coaster up and down.

Does this mean we can design portfolios than can return 10% consistently year after year? Of course not! But a core tenant of our investing process is to develop portfolio, that are expected to have less volatility and more consistent return sequences over time.