Intro
Naturally as humans, we want to chase the biggest and greatest returns. This incentive of wanting more, oftentimes leads us to act irrationally and take on greater risk.
Before you click off, I’m not here to make you put all your money in an index and give up, I would much rather you have the knowledge to be able to harvest the great potential returns you can make in small caps. But numbers don't lie.
Geometric Returns
The geometric return (also known as the compound annual growth rate) accounts for the compounding between specific sequences of returns. Which is important because a higher geometric return implies a faster rate of compounded investment.
The geometric return is a confluence more trusted by investors as it accounts for not only compounding, but volatility.
Arithmetic returns
The Arithmetic return is very commonly used to average out large datasets, however it is simply the average of periodic returns. It ignores compounding entirely, but that doesn’t make it useless.
The Artithemetic return is useful to traders, as if modeled correctly, it could be used to determine the moving average of a stock's price. But for the retail investor, who most likely doesn’t have high enough frequency computers to compete in those millisecond markets, it stands as an interesting topic to read about.
The Silent Killer of Geometric Returns
Volatility, more specifically the volatility drag created from the constant price movements of (for example) a small cap stock, greatly reduces the portfolio's ability to generate a strong geometric return.
As a matter of fact, chasing ephemeral gains would actually produce more arithmetic growth. In the model below we can see this phenomenon come to play.
We can see that in almost 50% of all paths produced, a portfolio generating a strong arithmetic return, will end up at break even or below the starting principal.
However, when we adjust the portfolio used in the model to generate a strong geometric return, after 30 years the worst possible outcome is still 2.4x your original investment.
How to actually slay the Volatility Drag-on
On the left portfolio, we see a 25% drawdown in a market shock event. On the right portfolio, it’s experiencing the same market shock event, but is paying a small premium for put options to hedge the damage.
Even though the portfolio is paying a small premium every single year for this hedge, in bear market scenarios this allows the investor to buy assets at an extremely discounted price compared to competitors, leading to a higher compounded annual growth rate.
This was my take on geometric returns, if you’re interested in the jupyter notebook I derived this data from it will be below.