The Investment Scientist

What Kills Investment Returns?

Posted on: November 23, 2019

Last week’s newsletter article “Why It’s Awesome To Have a Loser in Your Portfolio” has proven to be quite controversial. More than a few of my readers emailed me to warn that my Finance professor at Oxford was full of bullshit. Let’s put that aside for now, and consider this question:

If there is an investment that has an average return of 25%, would you invest in it? 

If you did not jump in right away, you are a smart investor! Investment A falls 50% in one year and gains 100% the next, giving it exactly a 25% average return. If you invest $1000, however, you make absolutely $0 on this investment. On the other hand, investment B gains 25% in both years, so it also has exactly a 25% average return, but now the gain from $1000 investment is $562.5. You can not pick an investment in isolation of its volatility. Because …

Volatility kills returns.

Now let’s assume you already have investment A, the high return but extremely volatile investment. Can you use a loser to turn the investment around? Let’s see …

Investment C gains 50% in the first year and falls 80% in the second year, it has an average return of -15%. If you invest $1000, you lose $700. It’s a total loser from any angle.

Now let’s create a portfolio made up of 50% Investment A (a loser that doesn’t make money) and 50% investment C (a total loser that lost money.) This gives you a portfolio that gains 0% in the first year and 10% in the second year (see the table below.) Now if you invest $1000, you earn $100 at the end.

unnamed (6).jpg

I’ve just shown you a very stylized example of how adding a loser to a portfolio significantly improves it. You might still wonder why? Because …

Volatility kills returns, but diversification kills volatility, thus reviving returns.

My Oxford professor was not full of bullshit after all.

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Michael Zhuang is principal of MZ Capital, a fee-only independent advisory firm based in Washington, DC.


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