How Volatility Destroys Your Returns Over Time

Managing Volatility: A Long-Term Investor’s Guide to Staying the Course

Volatility is a fact of life in financial markets. Prices fluctuate based on economic news, geopolitical events, investor sentiment, and more. While short-term market ups and downs can feel unsettling, understanding volatility is crucial to building long-term wealth.

In this post, we’ll break down what volatility really means, why it matters for your investment returns, and how to protect your portfolio from its potentially damaging effects. You’ll learn about volatility drag, diversification, dollar-cost averaging, and other strategies to help you stay on track through every market cycle.

What is Volatility?

Volatility refers to the degree of variation in the price of an asset over time. In simpler terms, it measures how much and how quickly investment prices move. High volatility means bigger swings in price, while low volatility means more stable prices.

Why should long-term investors care?

• Can lead to emotional decision-making and mistimed trades
• Increases risk when not properly managed

Understanding and managing volatility isn’t about avoiding it altogether, it’s about minimizing its impact on your long-term goals and ensuring your portfolio is equipped to weather turbulence.

Understanding Volatility Measures Like Beta

Two key measures of volatility are Beta and standard deviation:

Beta measures an investment’s exposure to systematic or market risk, this undiversifiable risk is driven by overall market forces including factors like changes in interest rates, inflation expectations, recessions, and political instability,  among others. A beta of 1 indicates the asset tends to move in line with the market. A beta above 1 indicates greater sensitivity to market movements, while a beta below 1 implies lower sensitivity.

Example: If a stock has a beta of 1.2, it’s expected to be 20% more volatile than the market, while a beta of 0.8 means the stock is expected to be 20% less volatile than the market. This is helpful for comparing stocks or funds to a benchmark like the TSX Composite Index.

Standard deviation, on the other hand, measures the total volatility of an investment, capturing how widely returns fluctuate around their average return. Unlike beta, which reflects only systematic risk, standard deviation accounts for both systematic and unsystematic risk (firm-specific risk). It is a core metric in modern portfolio theory used to assess overall portfolio risk.

Both metrics, when used together, offer a more comprehensive view of risk, helping investors build diversified portfolios that balance return potential with their risk comfort level reducing the chances of panic-selling during market swings. 

While beta and standard deviation help investors understand how an asset behaves in the short term, time itself is one of the most powerful volatility reducers.

The chart below illustrates this clearly, over 1, 3, 5, and 10-year periods, the range of outcomes or the swings in asset prices (standard deviation) narrows significantly. As investment horizons lengthen, short-term noise smooths out, and returns converge toward their long-term averages.

In other words, volatility fades with time, reminding investors that staying invested through market cycles is one of the most effective ways to avoid the emotional costs of short-term market swings.

The Hidden Cost of Volatility: Volatility Drag

Volatility doesn’t just make investors nervous, it can quietly eat away at long-term wealth through a concept known as volatility drag. To thoroughly understand volatility and its drag on returns, we first need to understand the difference between Arithmetic and Geometric returns.

Arithmetic vs. Geometric Returns

• Arithmetic return: This is the simple average of a series of periodic returns. For example, if you earn +30% one year and -10% the next, your arithmetic annual return is [30% + (-10%)] / 2 = 10%
• Geometric return: This reflects the compound annual growth rate (CAGR) of your investment over time. It considers the compounding effect and is generally lower than the arithmetic average when volatility is present. Therefore, it is considered a more accurate way to measure an investment. Using the same example above the geometric return will be, [(1+30%) * (1+(-10%))] 1/2 -1 =8.17%

Volatility drag is the gap between these two figures, about 1.83% and It arises because losses have a larger mathematical impact than gains. For instance:

• A 20% loss on $100 requires a 25% gain to recover (you need to gain $20 on $80).
• A 50% loss requires a 100% gain to break even (a 50% rise on $50 only brings you back to $75).

The greater the variability in your returns, the more compounding is hampered over time.

This phenomenon underscores the importance of not just chasing high returns, but also controlling the consistency of those returns through diversification, risk management, and strategic asset allocation. The key idea of a volatility drag is that losses hurt more than gains help.

Example:

• Year 1: +50% → $100 grows to $150
• Year 2: −50% → $150 drops to $75
• Net return: You’ve lost 25% ($100 to $75), even though the average return is (50% − 50%) ÷ 2 = 0%

This math shows how volatility can erode actual wealth even when the average return seems break-even. Recovering from losses becomes disproportionately harder the deeper the fall. Thus, the more your portfolio swings (i.e., higher volatility), the harder it is to grow wealth over time, that is the more consistent your returns need to be to truly build wealth.

Real-World Insight:

During the dot-com bubble burst (2000–2002), the Nasdaq fell nearly 78%. Even with substantial gains afterward, it took almost 15 years to recover. This is volatility drag in action.

Diversification: Your First Line of Defense

One of the easiest ways to avoid excessive volatility is to make sure all your eggs aren’t in one basket. When a single stock or asset class dominates your portfolio, a drop in that area can drive your entire return down. This is where diversification, a core principle of investment management, plays a vital role.

Diversification means spreading your investments across different asset classes and regions or sectors to reduce overall risk. By balancing exposures, investors can smooth out returns and limit the impact of any one investment’s decline.

Why it works:

• Not all investments move in the same direction at the same time
• It reduces exposure to any single economic event or sector
• It lowers portfolio volatility by combining uncorrelated or negatively correlated assets

Learn more about Diversification.

The Dangers of Market Timing

Trying to avoid market volatility altogether by timing your entry and exit, selling before a downturn and buying before a recovery, often does more harm than good.

The risks:

• Markets recover unpredictably: Sudden reversals are common, and waiting for the "right time" can leave you sitting in cash as markets soar.
• Missing just a few key recovery days can severely impact long-term gains: Research shows that the best days often follow the worst. Timing these exact moments requires a level of foresight no one truly has, not even the experts. Missing just a few of these key rebound days can significantly reduce long-term returns.

Example:

• Missing the 10 best months in the market over a 34 -year period (1990–2024) reduces total returns by 61%

• After the COVID crash in March 2020, global markets rebounded within months . Investors who pulled out missed the fastest bull run in history.

In other words, trying to sidestep volatility through market timing often leads to missing the very rebounds that drive long-term growth. Staying invested and disciplined, even through short-term turbulence, is far more effective than trying to predict what comes next.

Market volatility doesn’t just test portfolios, it tests emotions. Fear, greed, and overconfidence can push investors to make decisions that hurt more than they help.

• Fear leads to selling low: Panic during market downturns often causes people to sell after losses have already occurred.
• Greed leads to buying high: Jumping into hot sectors after they’ve already peaked can result in buying near the top where there is not much room left to see your investments grow.
• Recency bias causes investors to assume that recent trends (downturns or rallies) will continue: This leads to poor timing decisions based on short-term sentiment rather than fundamentals.

The good news? There are ways to stay disciplined and keep emotions in check. Dollar-Cost Averaging (DCA) and portfolio rebalancing are two simple, proven strategies that help investors stay consistent through all kinds of markets.

How Dollar-Cost Averaging Helps

Volatility can erode wealth over time. Dollar-cost averaging (DCA) helps soften this impact by spreading out investments over time.

By investing a fixed amount at regular intervals, regardless of market conditions, DCA allows you to buy more shares when prices are low and fewer when prices are high. This helps lower your average cost per share and reduces the risk of investing a lump sum just before a market drop.

While DCA doesn’t eliminate volatility, it helps manage its effects, encouraging long-term discipline and avoiding emotional, poorly timed decisions.

Benefits of DCA:

• Removes the pressure to time the market: You invest consistently, whether the market is up or down.
• Lowers average cost over time: Buying more units when prices are low naturally reduces your cost per share.
• Encourages disciplined investing: Regular contributions keep your portfolio growing, even during volatility.

Example:

Contributing $500/month into a diversified ETF like the iShares Core MSCI All Country World Index ETF (XAW) ensures you're buying through highs and lows. Over time, your average cost per unit balances out.

DCA helps investors stay engaged and avoids the paralysis of waiting for the "perfect" entry point.

Rebalancing and Risk Management

Even a well-diversified, consistently funded portfolio can drift off course over time, especially during volatile markets. Rebalancing helps keep that risk in check. Rebalancing means periodically adjusting your portfolio to restore your original asset allocation, for example, bringing a 60/40 stock-bond mix back to target after market movements. It’s a disciplined way to control volatility, prevent risk creep, and ensure your portfolio continues to reflect your long-term objectives.

Why Rebalancing Matters:

• Keeps your risk profile aligned with your goals: Without rebalancing, outperforming assets (like stocks during a rally) can dominate your portfolio, exposing you to more risk than you initially planned.
• Enforces buy-low, sell-high discipline: Rebalancing involves trimming assets that have surged and reallocating to those that have lagged, a systematic way to capture gains and reposition for future growth.
• Controls volatility and maintains discipline over time: Left unchecked, a portfolio can become overly aggressive or too conservative, both of which can erode long-term wealth and undermine your chosen strategy, especially during market swings.

Example:

If a 60/40 portfolio drifts to 75/25 after a strong equity rally, you’re now taking on significantly more market risk. Rebalancing brings the portfolio back to your original comfort zone.

Rebalancing can be scheduled (e.g., annually) or triggered when asset weights deviate beyond set thresholds (like 5%).

Staying the Course During Market Turmoil

The key to investment success and in a way avoiding excessive volatility is staying the course, remaining disciplined, trusting your strategy, and avoiding the temptation to react impulsively. By maintaining a long-term perspective, you avoid locking in losses during downturns and benefit from eventual rebounds, which are often both rapid and substantial. Remember, time in the market consistently outperforms timing the market.

Historical Examples:

• 2008 Global Financial Crisis: The S&P 500 dropped over 50% but more than doubled within five years.
• COVID-19 Pandemic: Global markets dropped 30% in weeks and recovered to new highs in less than 9 months.

Why staying invested matters:

• Recoveries often happen faster than expected
• Long-term investors benefit from compounding growth
• Volatility tends to smooth out over decades

Trying to predict short-term movements often results in missed opportunities. Staying invested increases the likelihood of capturing market rebounds and long-term wealth creation.

Conclusion

Volatility is an unavoidable part of investing, but it doesn’t have to derail your financial goals. When unmanaged, it can stealthily erode your returns through volatility drag, poor decision-making, and excessive risk exposure.

With the right strategies, diversification, dollar-cost averaging, rebalancing, and a long-term perspective, you can reduce its impact and stay focused on what matters most: your future.

Stick to the plan, ignore the noise, and let compounding do the heavy lifting.