Recent participants in the Dubai marathon will agree on one thing - slow and steady wins the race. The swift were initially exciting to watch but tired prematurely, while the methodical plodders preened at the feted finish. This preference for steady over jerky is also true in the sphere of personal investing. Steady investors accumulate capital at a higher rate than those who alternate between sprinting and limping, chasing hot investment trends one year and chastened to inaction by losses the next year.
The reason why steady beats frenetic in the investment race is mathematically simple - geometric returns lag arithmetic returns in volatile markets. First, let us agree that most investment markets have been difficult in the past decade and volatility has at times been vicious, a phenomenon likely to continue. How should we minimise the volatility of our investment portfolio while maintaining exposure to inherently volatile yet rewarding growth assets?
Second, all investors should recognise that lower portfolio volatility is desirable for long-term success. If you lose 20 per cent of your capital, you need to generate a higher return of, say, 25 per cent to get back to break-even, not to mention forgoing the opportunity cost of capital. The deeper the downturn, the truer it is: a 50 per cent loss requires a 100 per cent gain to break even. Let's compare two investment portfolios, called Steady and Jerky, evaluated over three years. Suppose Steady has a return pattern of 8 per cent, 10 per cent and 12 per cent in years one through three.
Sure, a flat 10 per cent each year is optimum, but in reality it cannot be generated. Steady's arithmetic return, or simple average, is exactly 10 per cent, and the geometric return, or compound average, is almost 10 per cent, for a total return of 33 per cent. Suppose the Jerky portfolio has a volatile return of negative 10 per cent the first year, records a 30 per cent gain in the second year, and ends up 10 per cent in the third. It has an arithmetical return of exactly 10 per cent as well, but a lower geometric return of 8.75 per cent.
While Jerky is more exciting to watch than Steady, it also exacts a greater toll on its owner's pocket, as she is forced to spend money on heartburn and blood pressure medications. The nearly 1.25 per cent difference in compound annual return is the price of entertaining yourself by buying into trendy ideas touted by your favourite pundit or banker; call it an excitement tax. How much does this seemingly small difference cost you in the long run? US$1 million invested in the Jerky portfolio grows to about $2.3m (Dh8.44m) in 10 years, compared to nearly $2.6m (Dh9.54m) in the Steady portfolio over the same period. The excitement tax just cost you a Ferrari.
The longer you compound, the sweeter it is. For example, a 50-year-old investor cashing out at 80 reaps a fabulous $5m more when selecting Steady over Jerky. Creating an unexciting but steady portfolio requires extra effort and skill. So how does one lower volatility while taking advantage of economic growth? Various techniques are available to market professionals, such as tactical allocation to high-grade fixed income products, hedging equity index downside through futures markets, trading volatility indices and more.
A judicious and flexible mix of these methods, depending on market conditions, liquidity and prevailing prices is essential. Whatever your unit of wealth, dirhams, dollars or dinars, the sizeable difference between the Steady and Jerky outcomes is real money, with enough utility to offset the boredom of watching Steady plod through the markets. If your knees are anything like mine, a heroic marathon is an unlikely feat, but with a sure and steady approach to managing investment portfolios anyone can successfully cross the investment finish line.
Rehan Syed is the head of portfolio management at ABN AMRO private bank in Dubai. The opinions expressed in this column are his and not necessarily those of his employer.