As a financial advisor or investor, you deal with all kinds of taxes.
Things like the capital gains tax and the income tax and on and on.
But have you ever heard of the “volatility tax”?
Don’t worry if you haven’t since it’s hardly ever mentioned.
But this tax – I believe – is the most insidious of them all for investment returns.
Because the volatility tax is the hidden tax that occurs from steep portfolio losses that crush long-term compounded returns.
It’s essentially a deceptive cost that will plague investors through negative compounding returns.
See, throughout history, markets seem to follow a pattern of boom-and-bust cycles – particularly with relatively slower rises over the years only to implode quickly.
For instance, the “roaring” 1920s was followed by a great depression. The post-1970s “Japanese miracle” was followed by the 1991 crash. And most notably, the early 2000s housing boom was followed by the great financial crisis of 2008-09.
And although these events are rare, all it takes is one large portfolio decline every now and then to really skew compounded returns.
So, if that’s the case, this poses two important questions:
1. How exactly do sudden market drawdowns affect long-term wealth creation?
2. How may investors instead take advantage of such scenarios to try and gain from the volatility?
Let’s break down the potential answers.
Beware The “Volatility Tax” – It Costs More Than Many Realize
As mentioned above, large and sudden drawdowns in asset values can wreck compounded returns.
Mark Spitznagel – President and Chief Investment Officer at Universa Investments – wrote a compelling paper1 on this, where he noted that, “The volatility tax is the hidden tax on an investment portfolio caused by the negative compounding of large investment losses.”
For example, imagine losing 50% in one year and making 100% the next year.
That would show an impressive 25% average annual return over that two-year period (using arithmetic).
Not bad, right?
Well, until you consider that you’re basically back where you started…
See, the geometric return (aka how money grows or shrinks over time) is what really matters here. And for this investment, it’s 0% - meaning that, on average, you neither gained nor lost money over the two-year period when accounting for compounding effects.
Thus, in this example, the volatility tax – which is the spread between the arithmetic return and the geometric return – is 25%.
This may seem a bit technical. But putting it simply; the bigger the volatility tax is, the fewer compounded returns there are.
Or – said otherwise – big drawdowns (even just one or two) may create negative compounding growth rates.
This is why Warren Buffet masterfully said2, “The first rule of an investment is don't lose [money]. And the second rule of an investment is don't forget the first rule.”
He understands how damaging large losses can be for generating long-term returns – which is what truly matters.
It just takes too long to recover from and at a much lower starting point than before.
Now, this isn’t to say that arithmetic returns (average) are pointless.
But rather for long-term investing, geometric (compounding) returns seem more important because they reflect the true growth rate over time.
This is why large sudden drawdowns – like 2008 – can impact wealth so drastically over the long term.
The years of steady compounding returns may be crushed in the blink of an eye.
Or, as the old saying goes; five steps forward, six back.
Now, you may be thinking, “This makes sense. But how does one even avoid a situation like 2008? Or any sudden decline?”
Well, that’s the big question. Because no one will ever really know when or where a black swan – a random, extreme, and rare event that occurs – will show up.
But instead of trying to guess if or when it will ever show up – I believe it’s more important to focus on hedging for if that day ever happens.
Antifragile: Things That Gain From Disorder and Volatility
You’ve probably heard the names Michael Jordan or Scottie Pippen before and how they won six NBA titles in the 1990s.
Jordan is arguably the best scorer in NBA history. And Pippen’s considered one of the best well-rounded players of his era.
And while they’re great at what they did – many forget one of the biggest pieces to the Bull’s “three-peat” (1996-98 championship wins).
And that was Dennis Rodman.
See, Rodman wasn’t a scorer. But he did one thing very well.
Which was grabbing rebounds (he averaged over 15 rebounds per game but scored only 5.2 points per game while in Chicago).
In fact, Rodman once said, “I want to do for rebounds what Michael Jordan did for dunks.”
Why? Because he understood that to win, he had to get the ball back into Jordan’s hands.
Or – said another way – Rodman’s sole purpose was to take advantage of missed shots and recycle them back to his team so that they could try scoring again.
So, why does this matter?
Because many investors may often set up their portfolios (or their wealth managers set them up for them) to try and hit those big returns, but in doing so, they neglect how important defense or hedging is until it’s too late.
And this creates ‘fragility’.
Simply put, anything that’s fragile is harmed by volatility, randomness, and disorder (like only focusing on scoring).
But why not look at harnessing any potential volatility or disorder and instead potentially benefiting from it (like capitalizing on rebounds)?
This is known as ‘antifragile’ – a term coined by Nassim Taleb – about gaining from disorder, which is the exact opposite of something that’s fragile.
Here are two fun examples showing the difference between fragile and antifragile:
1. The Sword of Damocles – an ancient moral parable popularized by the Roman philosopher Cicero in 45 B.C. that emphasizes the constant threat hanging over Damocles’ head (which was a sword dangling above where he sat – held by nothing more than a horsehair).
Thus, Damocles was sitting on the throne, lavished by servants and feasts, but was always under threat that a sword would simply fall on his head at any moment.
The parable later became a common motif in medieval literature, and the phrase “sword of Damocles” is now commonly used as a catchall term to describe a looming danger.
This is a great example of fragility.
2. The Hydra – a hideous serpentine water monster from Greek mythology that was slayed by Hercules as part of his Twelve Labors.
The large snake possessed many heads. And each time one was cut off, two more would grow in its place.
In fact, Hercules could only kill it by having his cousin – Iolaus – help him cauterize the hydra’s neck wounds to prevent any further regrowth.
This is an example of antifragility.
Because the hydra actually gained from being beheaded (more would grow back). So it would strengthen as the fight and damage increased.
Now, while these are great ways to understand the basics of fragility and antifragility, here’s a great visualization3 of the two.
Figure 1: innolution.com
Imagine a portfolio that depends on income through selling options (aka income paid from the selling of an option contract upfront).
The option seller will most often collect the small premium. And over time, the contracts will expire worthless for the buyer.
But – as the chart shows above – this is relatively fragile.
Because the upside is capped (the premium collected) whereas the downside could be significant (if a spurt of volatility hits).
And vice versa for those who bought the options.
Or imagine how automobile insurance companies work.
They sell insurance for a small upfront premium, hoping that vehicle accidents remain light.
And more often than not, this is a profitable business model.
That is until it isn’t…
For instance, if there was a sudden and random surge in vehicle accidents, it could put the insurer in big trouble as their liabilities soar. Meanwhile whoever bought the insurance is benefiting (the small monthly premiums they’ve paid for may now get them a brand-new car if the damage is bad enough).
This is the core issue with anything that’s fragile. Because all it takes is one random and turbulent event to cause serious damage.
And because of this, it may seem prudent for investors to look into assets or positions that offer upside protection from random events.
Or – tying it back to earlier – mitigate the downside of the volatility tax by gaining from any potential disorder or missed shots. Do not suffer from it (aka don’t forget about Rodman).
In the world of finance and investing, the concept of returns is more nuanced than it may initially appear. It's not just about achieving high average annual returns; it's about understanding how money grows or shrinks over time, especially when considering the impact of compounding effects.
The "volatility tax" teaches us a valuable lesson. It underscores the importance of guarding against large and sudden drawdowns in asset values, as they can have a profound impact on long-term compounded returns.
I believe it's not enough to merely shield oneself from adverse events. Because as history shows, it’s very difficult.
Instead, the concept of "antifragility" opens a fresh perspective.
Much like Dennis Rodman's pivotal role in the Bulls' championship victories, where his rebounding secured success, investors can learn to gain from market volatility and black swan events rather than being harmed by it.
This approach signifies a shift from a defensive strategy to a proactive one, turning market unpredictability into an asset rather than a liability.
Thus, as we navigate the complex terrain of investment, it's important to weigh both the fragility and antifragility of financial strategies.
By doing so, investors can hopefully strive to not only safeguard wealth from the uncertainties of the market. But also, possibly turn those uncertainties into opportunities.
If anything you read strikes as compelling, please feel free to reach out to us and see what Dunham is working on.
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