There are broadly two camps when it comes to how an investor should construct a portfolio. On one side, we have those who advocate not putting all your eggs into one basket. In other words, ensure your portfolio is well-diversified such that portfolio volatility is kept to a minimum. On the other side, we have those who advocate putting everything into one basket and watching that basket closely. People who advocate this usually put on concentrated bets based on a handful of securities. They say that volatility is not important as long as they believe in their long-term investment thesis.
There is no easy way to decide which camp has a better chance of investing success in the long-term because there are success cases in both. However, the laws of mathematics suggest that it is more difficult to generate long-term returns if portfolio volatility is high. Let's go through two simple scenario exercises to see why.
Average Investors
Let's say we have two average investors A & B who are equally likely to profit or lose money in any trade. The only difference is that A tends to trade stable stocks while B tends to trade volatile stocks. When A wins, he makes 1% but when he loses, he loses 1%. When B wins, he makes 10% but loses 10% otherwise.
Let's assume that both investors' portfolios alternate between gains and losses every day. Now, we all know that for every percentage loss in the portfolio, we need to make back a higher percentage gain to break even. Therefore, we know that over time, both investors would lose money. We can easily find out the outcome by simulating it in Excel.
After 10 years, the portfolio with low volatility would still be worth about 88 cents on the dollar. However, the portfolio with high volatility would have lost almost everything even way before the 10 years is up.
Skillful Investors
Some might say that investor B lost everything because he did not have an edge. Ok, fair enough so let's now look at two skillful investors C & D. C likes stable stocks while D likes highly volatile stocks. When C wins, he makes 1.05% but he loses 1% on a bad day. In other words, he only has a slight edge of 0.05%. D has a higher edge of 1%. He makes 11% on a good day but loses 10% on a bad day.
Again, let's assume that both investors' portfolios alternate between gains and losses every day for 10 years.
Notice how the portfolio with low volatility can grow over time even on a tiny winning edge. The highly volatile portfolio did not turn out as bad as before thanks to the 1% winning edge. However, it still lost about 70% after 10 years. The greater the volatility of a portfolio, the more sensitive it is to the winning edge. If we increase the edge slightly to 1.1%, the portfolio would have been able to keep most of its value after 10 years. This is why high volatility is associated with uncertainty.
Conclusion
You need a lot of skill to ensure a positive long-term outcome if you want to run a portfolio with high volatility. And even so, a slight miscalculation can mean a disaster that is difficult to recover from. It is like driving an F1 car down a narrow street. Running a portfolio with low volatility only requires a small edge to be successful and the risk of not hitting the target is lower.
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