New Here? Get the Free Newsletter

Oblivious Investor offers a free newsletter providing tips on low-maintenance investing, tax planning, and retirement planning. Join over 21,000 email subscribers:

Articles are published Monday and Friday. You can unsubscribe at any time.

Greater Volatility = Greater Returns

Imagine that you’re given the choice between:

  • Investing $1,000 in an investment with a fixed 8% annual return, or
  • Investing $1,000 in an investment that has averaged an 8% annual return over its life, but has historically been rather volatile, earning a positive return in some years and negative return in others.

Which would you choose? I’d imagine that most people would choose the one with a fixed return. In fact, that’s likely the one I’d choose as well.

Now imagine this slightly different scenario: You recently came upon a new income stream of $1,000 per year. You don’t need the money, so you plan to invest it. Your two options are:

  • Investing $1,000 per year in an investment with a fixed 8% annual return, or
  • Investing $1,000 per year in an investment that has averaged an 8% annual return over its life, but has historically been rather volatile, earning a positive return in some years and negative return in others.

In this scenario, which option would you choose? The fixed rate still feels rather attractive. Dealing with uncertainty is difficult, so it’s nice to know exactly what you’re going to get.

On the other hand, if the volatile investment continues to earn an 8% annual return on average–even though it’s year-by-year returns fluctuate a great deal–it’s going to earn you more money.

Why is this?

When dollar-cost-averaging, greater volatility means greater returns. It doesn’t necessarily seem intuitive, but let’s look at the math. [Please note that the following analysis applies only when dollar-cost-averaging into an investment.]

Scenario 1

The following spreadsheet snippet shows our zero-volatility example. (You’re investing $1,000 per year, and the investment earns exactly 8% each year.) As you can see, at the end of the period, you would have invested $3,000, and it would have turned into $3,506.

  • Average return earned by the investment: 8%
  • Volatility: None
  • Amount of money at the end: $3,506.11
  • Return earned on your investment: 8%.

Scenario 2

This next spreadsheet shows a scenario in which the investment still averaged the same exact 8% annual return. (That is, it still started at a $100 share price and three years later had a share price of $125.97.) However, in this scenario–in Years 2 and 3–the investment fluctuated in price from our base-line, 8%-every-year scenario. This time, instead of the share price in Year 2 being $108, it was $128 (or $20 higher). And in Year 3, instead of $116.64 it was $96.64 ($20 lower).

  • Average return earned by the investment: 8%
  • Volatility: $20 upward, followed by $20 downward
  • Amount of money at the end: $3,547.34
  • Return earned on your investment: 8.62%.

As you can see, adding some volatility into the scenario did, in fact, increase your return. In short, this is because Dollar-Cost-Averaging into a volatile investment sets you up to automatically take advantage of price swings by buying more shares when the price is low.

OK, so volatility helps your return in that scenario. But what about in other situations? For example, what happens when the price swings happen in the other order (downward first, followed by upward)?

Scenario 3

This scenario is exactly the same as Scenario 2, but with downward volatility first, followed by upward volatility. So the share price in Year 2 is $88 ($20 lower than the original $108), and in Year 3 the share price is $136.64 ($20 higher than the original $116.64).

  • Average return earned by the investment: 8%
  • Volatility: $20 downward, followed by $20 upward
  • Amount of money at the end: $3,613.09
  • Return earned on your investment: 9.59%.

As you can see, the results are even better than in Scenario 2.

So far, we can conclude that some volatility is better than no volatility and that it’s beneficial regardless of the order in which it occurs. So what happens when we increase the volatility further?

Scenario 4

Scenario 4 is the same as Scenario 2, except the volatility is in the degree of $50 rather than $20.

  • Average return earned by the investment: 8%
  • Volatility: $50 upward, followed by $50 downward
  • Amount of money at the end: $3,947.28
  • Return earned on your investment: 14.36%.

Wow. Look at that return! Earning a 14% return on your money while investing in something that only earned an 8% return over the period is pretty impressive.

Why does volatility increase returns?

  • When you’re DCA’ing into an investment, you’re automatically buying more shares when the market is low, and fewer when the market is high. (“Buy low. Sell high.”)
  • Increased volatility simply creates a situation in which the market lows are lower, thereby making your DCA’ing more effective.

Overall Lesson

If you’re dollar-cost-averaging into an investment, greater volatility means greater returns. In other words, the volatility of the stock market isn’t just something you have to put up with in order to earn superior returns. It’s actually an essential factor that directly improves your return.

New to Investing? See My Related Book:

Book6FrontCoverTiltedBlue

Investing Made Simple: Investing in Index Funds Explained in 100 Pages or Less

Topics Covered in the Book:
  • Asset Allocation: Why it's so important, and how to determine your own,
  • How to to pick winning mutual funds,
  • Roth IRA vs. traditional IRA vs. 401(k),
  • Click here to see the full list.

A Testimonial:

"A wonderful book that tells its readers, with simple logical explanations, our Boglehead Philosophy for successful investing." - Taylor Larimore, author of The Bogleheads' Guide to Investing

Comments

  1. Good job on explaining one of the key benefits of DCA, Mike! There are a lot of naysayers out there, but you just can’t beat the simplicity and strength of a good DCA plan. Keep up the good work!

  2. Hi SR. Thanks for commenting and tip’ing. 🙂

    You make valid points. I was, however, actually basing the article on an entirely different assumption: That the investor is DCAing into a diversified mutual fund (index or otherwise), rather than into an individual stock.

  3. Singapore Recession says:

    Hi,

    Thanks for the great post! I have Tip’d!

    However, I think it is necessary for you to point out clearly, to newbie investor readers out there, that the purpose for this post is to purely show that volatility is actually good for dollar cost averaging strategy with the following assumptions:

    1. the company does not go into credit default
    2. the company’s share price continue to grow higher forever
    3. the investor know when to take profit
    4. This is only one of the factor and by no mean the only factor to improve the investment
    5. DCA forever regardless of market condition

    The reason is because, imagine if you have use DCA strategy on Citi or AIG … how would your investment looks like if you have started investing 10 years? -75%

    just my 2 cents 🙂

  4. Singapore Recession says:

    Thanks for clarifying.

Disclaimer: By using this site, you explicitly agree to its Terms of Use and agree not to hold Simple Subjects, LLC or any of its members liable in any way for damages arising from decisions you make based on the information made available on this site. I am not a financial or investment advisor, and the information on this site is for informational and entertainment purposes only and does not constitute financial advice.

Copyright 2019 Simple Subjects, LLC - All rights reserved. To be clear: This means that, aside from small quotations, the material on this site may not be republished elsewhere without my express permission. Terms of Use and Privacy Policy

My new Social Security calculator (beta): Open Social Security