How volatility drag can wipe you out

You may not recognize its name, but I’m confident that volatility drag has been hard at work eating into your finances.

It’s a slightly opaque financial force that (at best) pockets a share of our money every year, and (at worst) wipes traders out.

And the harsh reality is that it wipes out traders far more often than you might think – in fact, it’s a major factor in novice (and not so novice) investors walking (or limping) away from the markets.

Make sure it doesn’t catch you out.

What is volatility drag?

Let’s say that we have £1,000 to invest, and we expect to make 20% profits on a good year, and 18% losses on a bad year. And we get 50% good years, 50% bad years. It’s not a big margin, but if you’re making more than you’re losing, you should expect to come out on top … right?

Here’s how the first ten years might go …

starting fund:	£1,000
+20%	£1,200
-18%	£984.00
+20%	£1,180.80
-18%	£968.26
+20%	£1,161.91
-18%	£952.76
+20%	£1,143.32
-18%	£937.52
+20%	£1,125.02
-18%	£922.52

Your average annual return is +2%, but because of the volatility of the 20% upswings and 18% downswings, this is being eaten away by compound investing. And you’re left with less money than you started with.

This effect is at work across all our individual trades.

It’s why slow and steady profit plans can often outstrip those that post big winning spikes.

But what I really want to show you is how this volatility drag can too easily throw you out of the trading game altogether.

Point of pain

What causes traders to give up and walk away from the markets as a route to investment?

Generally it’s a drawdown.

Let’s say that you start off with £4,000 to invest. And you’ve reassured yourself (as you should) that this is money you can afford to lose.

At what point does a run of losses start to really hurt?

When you’ve lost £500?

When you’ve lost £1000?

When you’ve lost £2,000?

All losses are uncomfortable, but I expect that for most people the throw-in-the-towel point of pain is somewhere between 25% and 50% drawdown.

So, if you’re trading with £4,000, you may start questioning whether to continue if your fund drops down to £3,000.

How tiny differences in risk levels can push you beyond your point of pain

Next I’d like to show you one month’s worth of trading with a profitable strategy across 75 trades …

This shows I’ve been risking 0.5% of a £4,000 fund on each trade, compounding as I go.

At the end of the month, I’m 3.46% up, and the biggest dip below that £4,000 was to £3,900, which I felt pretty comfortable with.

I’m pleased with how my trading is going, so I’m going to bump up my risk per trade to 5%.

Here’s what happened with exactly the same trades, but with a 5% risk per trade …

I’ve now made over 29% gains in just 4 weeks, which I should be delighted with!

However, what will have happened to 9 out of 10 traders is that they’ll have thrown in the towel after that nasty drawdown of over £1,500 early on in the month (probably not even reaching the £2,000 drawdown that happened later in the month).

Even risking a more modest 2% per trade still bumps up the volatility of returns significantly, as you can see from this results chart showing exactly the same trades with a 2% risk …

And bear in mind – this is showing a PROFITABLE month. What if we up our risk levels and get a bad month?

The results shown so far are for 75 trades in a month, with a win rate of 58% and a 1:1 risk-reward.

What about a modestly bad month, in which my win rate dipped 42%?

Here’s how that would look for a 5% risk-per-trade …

That’s a whopping 36% loss, with a low of £2,350 – enough to scare the most resilient traders. (If we’d stuck with 0.5% risk, the loss would only have been 3.5%.)

This happens again and again to traders – I know, I’ve done it myself. We’re pleased with our results, so we up our risk levels (even modestly). Yes, this’ll mean bigger profits, but we don’t think enough about the volatility this will add to our returns.

Getting greedy always leads to traders blowing out, but what I hope this shows is that just small risk increases (the kind that we wouldn’t normally think of as greedy) can be the trigger.

How to combat volatility drag

Market returns are, by their nature, volatile. We can’t get rid of volatility drag altogether.

But I hope you can see that the effect of volatility isn’t just on our long-term results – it can too easily bump us out of trading altogether.

The best way to combat this is to keep your risk-per-trade very modest. If or when you do decide to increase your risk level, make very small changes over time and be aware that you’ll see an increase in volatility. That way, you can ease yourself into a level that you’re comfortable with, rather than giving yourself nasty surprises.

Yes, this means you won’t see such big profit percentages each month, but it also means that you’ll still be in the game a few years down the line, accumulating some real wealth, rather than just a flash in the pan.

 

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