What Is the Volatility Tax?

April 19, 2024
Estimated Reading Time: 6 Minutes

Compounded returns can significantly boost the growth of your investment portfolio over time, making it a key strategy for building wealth. However, if your portfolio isn't effectively diversified, it could be more adversely affected by volatility, which could reduce your portfolio's compounded returns -- a concept we at Chicago Partners refer to as the "volatility tax."

In this article, we'll discuss the volatility "tax" and demonstrate its effects on portfolio performance. We'll also explore how the relationships between investment assets affect how a portfolio reacts to volatility. Finally, we'll talk about the benefits of asset diversification.

What is the volatility tax?

The volatility "tax" is the effect of volatile market movements on a portfolio's total compound return. Market volatility can be influenced by a variety of factors. Economic data releases such as GDP growth, employment reports, and inflation figures can significantly impact market sentiment and lead to increased volatility. Fear, greed, and uncertainty can amplify volatility, leading to rapid price movements. Similarly, political instability, conflicts, trade tensions, and geopolitical events can create uncertainty in the market, leading to fluctuations in prices as investors react to changing circumstances. Lastly, changes in interest rates set by central banks can affect borrowing costs, consumer spending, and investment decisions, leading to market volatility (especially in interest rate-sensitive sectors like real estate and finance).

Time is an essential aspect of compound returns -- the longer you stay invested, the greater the impact on your portfolio. If your portfolio includes several investment vehicles that are highly susceptible to volatility, the volatility "tax" could be a sizable factor in your portfolio's performance.

Here's what the volatility "tax" looks like in a hypothetical portfolio.

Exhibit 1: A comparison of an example portfolio with consistent investment and an example portfolio with volatile investment; Source: Chicago Partners. *These are not examples of real portfolio performance and are included for demonstration purposes only.*

In Exhibit 1, the example portfolio on the left has a consistent compound return of 9% per year for 10 years. The example portfolio on the right has an average return of 9% over 10 years, but because there's volatility, it's only compounding at 5.94%.

Investment Assets and Their Correlations

The degree to which the volatility "tax" impacts a portfolio depends on how the investment vehicles within the portfolio are related. Investments can be positively correlated, negatively correlated, or have no correlation.

When two asset classes have a positive correlation, they tend to move in the same direction, meaning their prices rise and fall together. For example, large-cap stocks and mid-cap stocks can exhibit positive correlation, particularly during periods of overall market strength or economic expansion. They're both part of the equities market and can be influenced by similar macroeconomic factors, industry trends, and investor sentiment.

When two asset classes have a negative correlation, they move in opposite directions. An example of this type of correlation is interest rates and bond prices. When interest rates rise, newly issued bonds come with higher coupon rates to attract investors. These higher rates make existing bonds with lower coupon payments less attractive in comparison, causing their prices to fall. Conversely, when interest rates fall, existing bonds with higher coupon rates become more valuable, leading to an increase in their prices.

Non-correlated or lowly-correlated assets have little to no discernible relationship and tend to move independently of one another. An example of asset classes that are may not have high correlations could be stocks and alternative investments, such as hedge funds, private credit, and venture capital. These investments often have unique risk-return profiles and may be less affected by broad market movements, unlike traditional stocks.

Is there an "ideal" mix of asset classes for a portfolio?

In their book The Holy Grail of Investing, Tony Robbins and Christopher Zook share strategies and insights on investing that they gleaned from interviews with some of the world's most successful investors, including Ray Dalio. According to Ray Dalio, "the Holy Grail is a portfolio of eight to twelve uncorrelated investments which, together, will dramatically reduce risk without sacrificing returns."

However, it can be difficult to find 12 high-quality investment vehicles that are all perfectly uncorrelated. Instead, one strategy an investor might explore is to incorporate unique investments that are not highly correlated to reduce the impact of volatility within the portfolio. Having a mix of investment vehicles that react differently to market movements could lessen the impact of the volatility "tax" on the portfolio's performance. The graph below helps illustrate this concept.

Exhibit 2: A graph comparing the number of assets in a portfolio to the amount of volatility or risk in the portfolio; Source: CAZ Investments and Chicago Partners
This graph shows the relationship between the number of uncorrelated assets in a portfolio and the amount of volatility or risk that could be present in the portfolio. For example, if there are only 2 uncorrelated investments, the risk in the portfolio could be around 8%. Doubling the number of uncorrelated investments to 4 could reduce the amount of risk by 50%, and increasing the number of uncorrelated investments to 12 could result in an 80% reduction in risk.

The Importance of Asset Diversification in Portfolio Performance

Diversification helps spread investment risk across different asset classes, industries, sectors and geographic regions. When one asset class performs poorly, others may perform better, reducing the overall impact of any single investment's poor performance on the portfolio.

In addition to reducing risk, asset diversification could:

  • Provide stability: Diversification can provide stability to a portfolio by reducing its sensitivity to the performance of any single asset or market segment. This stability can help investors stay the course during periods of market volatility and economic uncertainty.
  • Smooth returns: Having a diversified portfolio can smooth out the volatility of investment returns over time. By holding assets with low or negative correlations, the gains from one asset may offset the losses from another, which could result in more consistent portfolio performance and reduce the impact of the volatility "tax" on the portfolio.
  • Reduce overexposure: Diversification may help avoid overexposure to any single asset class or investment, which could reduce the risk of significant losses if that asset performs poorly. It prevents the portfolio from being overly reliant on the success of a single company, sector, or market.
  • Enhance long-term growth: A diversified portfolio could experience long-term growth by balancing risk and return. While some asset classes may offer higher potential returns, they could also come with higher risk. By diversifying across a mix of assets with different risk-return profiles and low correlation, investors can pursue growth while managing risk effectively.
  • Align goals with risk tolerance: Diversification allows investors to tailor their portfolios to match their investment goals, time horizon, and risk tolerance. By selecting a diversified mix of assets that aligns with their objectives, investors can better manage risk and increase the likelihood of achieving their financial goals.

Consider reviewing - and rebalancing - your portfolio's asset allocation.

By investing in assets with low or negative correlations, investors may offset losses in one asset class with gains in another, thereby smoothing out portfolio volatility. It's important to keep in mind that over time, the performance of different asset classes may deviate from their target allocations. Rebalancing involves periodically adjusting the portfolio to bring it back in line with the desired asset allocation. This can help the investor maintain diversification benefits and manage risk.

If you'd like to learn more about the investment strategies we use for our clients, we invite you to contact one of our Wealth Advisors. Or, if you'd like to receive a complimentary Portfolio X-Ray that examines your portfolio's asset diversification, you can contact us here.

Important Disclosure Information

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