The problem is that these expected returns are, in most cases, single year forecasts.
A multi-year version of the efficient frontier sits below that of the single-year version and extremely risky/volatile portfolios are much less attractive than they first appear.
And whilst taking more risk still leads to higher forecast multi-year returns over most of the curve, at extreme volatility levels taking more volatility can actually decrease forecast returns – an inversion of the usual relationship.
This has pretty wide reaching implications:
* Advisers often use over-optimistic assumptions for cash flow modelling
* Investment managers don’t diversify enough and may run too much volatility in high risk portfolios
* Clients sometimes take the wrong amount of risk and/or are disappointed by the long-term returns they receive.
All-in-all, the fact that volatility negatively influences long-term returns as well as being a component of risk is pernicious and, unfortunately, inescapable.
Awareness of the issue is the only defence as it allows the effect to be carefully reflected in financial tools and financial planning and investment decisions.
Nic Spicer is portfolio manager of PortfolioMetrix
