Returns · 6 min read

Volatility drag: why the average return isn't what you get

Two investments with the same average yearly return can end up far apart. The one that swings more grows less, because losses and gains don't cancel out the way averages suggest.

Illustrations are plain arithmetic. Market figures are Canadian-dollar returns before inflation, 1977 to 2025.

The usual compound-interest example assumes the same return every year: 8% this year, 8% next year, and so on. Real investments don't behave like that. They might rise 25% one year and fall 10% the next. Their average yearly return can look identical to a steady 8%, yet the money at the end is smaller. The gap has a name: volatility drag.

The simplest example

Start with $100. In year one it rises 50% to $150. In year two it falls 50%, to $75. The average of the two yearly returns is zero (+50% and −50%), but the investment has lost a quarter of its value.

The reason is that each percentage applies to a different starting amount. The 50% gain was earned on $100; the 50% loss hit $150. Losses always need bigger gains to recover:

• A 20% fall needs a 25% gain to get back to even.
• A one-third fall needs a 50% gain.
• A 50% fall needs a 100% gain.

That asymmetry is what volatility drag is made of. The bigger the swings, the bigger the gap between the simple average and the growth that actually compounds.

Same average, very different endings

A longer example makes the effect clearer. Each case below averages 8% a year over 30 years, starting from $10,000. The only difference is how much the returns swing around that average. With swings of ±20%, for example, the returns alternate between +28% and −12%.

Arithmetic illustration: $10,000 over 30 years, returns alternating above and below an 8% average. Not market data.

Every row has the same 8% average. Yet the compound growth rate falls from 8% a year with no swings to about 7.5% with ±10% swings, about 6.1% with ±20%, about 3.75% with ±30%, and only about 0.3% with ±40%. In the wildest case, 30 years of "8% average" returns barely beat leaving the money under a mattress, before inflation.

A rule of thumb for the size of the drag

There's a handy approximation that links the two numbers:

The "yearly swing" here is the standard deviation, a measure of how far returns typically land from their average. With ±20% swings, half the square is 0.20 × 0.20 ÷ 2 = 0.02, or 2 points. So an 8% average should compound at roughly 6%, close to the exact 6.1% above. The formula also shows why the drag grows quickly: doubling the swing roughly quadruples the drag.

What it looked like in real markets

The same gap shows up in actual returns. The table compares the simple average of yearly returns with the compound growth rate for four Canadian-dollar series from 1977 to 2025, before inflation.

Stocks: Kenneth R. French Data Library, converted to CAD with Federal Reserve exchange rates. T-bills and bonds: Statistics Canada (bonds estimated from Government of Canada yields). Summary figures only.

Two patterns stand out. First, the drag tracks the swings: T-bills barely moved and lost almost nothing to drag, while Canadian stocks swung the most and lost about 1.2 points a year. Second, spreading money across many countries reduced the swings. Global stocks swung less than Canadian stocks alone and gave up less to drag, which is one reason diversification can raise long-run compound growth without changing the average return of the parts.

Why it matters

Volatility drag is easy to miss because the two kinds of "average" get used loosely. A forecast built on the simple average of yearly returns will overstate how much money accumulates. When comparing figures, it helps to check whether a number is an average of yearly returns or a compound annual growth rate. The compound rate is the one that turns into dollars.

It also explains a few things that otherwise seem odd. Borrowing to invest magnifies the swings, and because the drag grows with the square of the swing, it can eat much of the extra return. A portfolio that falls sharply needs a much larger rebound just to get back to where it was. And two portfolios with the same expected average can reasonably be expected to end up apart if one swings much more than the other.

None of this means volatile assets are a bad idea. Over long periods, stocks have historically compounded faster than bonds or cash despite the drag. It means the swings carry a real cost, and the honest way to compare investments is by what they compound to, not by their simple average.

Educational, not investment advice. The same information is shown to every reader and doesn't consider anyone's situation. Past returns don't guarantee future results.