How Volatility's Impact on Compounding

Volatility significantly affects compounding due to the phenomenon called volatility drag. In simple terms, higher volatility can reduce the average compounded growth of an investment.

The reason is that compounding works on consistent growth. When returns fluctuate significantly, the compounding effect diminishes, as losses require disproportionately higher gains to recover.

Illustrating with an Example

Assume two funds:

Fund A: A pure equity fund with higher volatility (e.g., annual returns can range between -20% and +30%).

Fund B: A dynamic hybrid fund with lower volatility (e.g., annual returns range between -5% and +15%).

Investment Assumptions

Initial investment: ₹1,00,000

Investment period: 5 years

Scenario: Calculating Returns

Year     Fund A Return     Fund B Return

Year 1           +30 %                  +12%

        2           - 20%                   +8%

        3           +25%                    +10%

        4           - 15%                    +5%

        5           +20%                    +10%

Final Values:

1. Fund A (Pure Equity)

After 5 years:

₹1,00,000 × (1 + 0.30) × (1 - 0.20) × (1 + 0.25) × (1 - 0.15) × (1 + 0.20)

= ₹1,00,000 × 1.3 × 0.8 × 1.25 × 0.85 × 1.2 = ₹1,37,280

2. Fund B (Dynamic Hybrid)

After 5 years:

₹1,00,000 × (1 + 0.12) × (1 + 0.08) × (1 + 0.10) × (1 + 0.05) × (1 + 0.10)

= ₹1,00,000 × 1.12 × 1.08 × 1.10 × 1.05 × 1.10 ≈ ₹1,64,450

Key Insights

1. Volatility Drag: Fund A had higher average returns (mean = +8%) than Fund B (mean = +9%). However, due to greater fluctuations, Fund A's compounded growth is lower.

2. Consistency Over High Peaks: The hybrid fund outperformed despite lower peak returns because steady compounding beats erratic growth in the long term.

Which is Better for Investors?

Fund A (Pure Equity) Best For:

Risk-tolerant investors with long-term horizons (10+ years).

Those who can weather short-term volatility and aim for higher absolute growth over decades.

Fund B (Dynamic Hybrid) Best For:

Conservative investors who prefer stability and moderate growth.

Short-to-medium-term goals (5-10 years).

Retirees or those nearing financial goals.

Conclusion

For most retail investors, the dynamic hybrid fund offers a balanced approach, ensuring growth with less risk of capital erosion. However, for aggressive long-term investors, pure equity funds can generate superior returns if held through market cycles and volatility.

To assess the volatility of a mutual fund and avoid highly volatile funds, you can look at the following key parameters:

1. Standard Deviation (SD):

What it measures: The degree to which a fund's returns deviate from its average return over a given period.

How to interpret:

Higher standard deviation = Higher volatility.

A fund with an SD of 15% is more volatile than one with 10%.

Usage: Compare funds within the same category (e.g., compare equity funds to equity funds).

2. Beta:

What it measures: A fund's sensitivity to market movements.

How to interpret:

Beta = 1: Moves in line with the market.

Beta > 1: More volatile than the market.

Beta < 1: Less volatile than the market.

Usage: Ideal for comparing funds to a benchmark index like Nifty 50 or Sensex.

3. Sharpe Ratio:

What it measures: Return per unit of risk (volatility).

How to interpret:

Higher Sharpe Ratio = Better risk-adjusted returns.

A fund with a higher Sharpe Ratio might have better stability despite returns.

Usage: Focus on funds with higher Sharpe Ratios for efficient risk management.

4. Sortino Ratio:

What it measures: Return per unit of downside risk.

How to interpret:

A higher Sortino Ratio indicates that the fund has lower downside volatility and is better at protecting capital during downturns.

Usage: Especially useful for conservative investors who are more concerned about losses.

5. Rolling Returns Volatility:

What it measures: Consistency in returns over various time periods (e.g., 1-year, 3-year, 5-year rolling returns).

How to interpret:

Lower fluctuations in rolling returns indicate lower volatility.

Usage: Look for funds with smoother rolling return graphs.

Additional Factors to Consider

1. Category: Debt funds, hybrid funds, and balanced advantage funds are typically less volatile than pure equity funds.

2. Fund Size: Very small or very large funds might show higher volatility due to liquidity issues or portfolio inflexibility.

3. Fund Manager Consistency: Check if the fund's manager has been consistent in maintaining volatility levels over the years.

How to Use These Parameters

1. When selecting a fund, compare the standard deviation and beta within the same category.

2. Use Sharpe Ratio and Sortino Ratio to evaluate if the returns justify the risk.

3. Look at historical rolling returns for consistency and long-term trends.

By focusing on these metrics, you can effectively avoid highly volatile funds and choose those with consistent, risk-adjusted performance.