Volatility drag and the cost of big swings
Posted: Wed Oct 28, 2026 6:04 am
Consider an account that gains 50% one month and loses 50% the next. The arithmetic average return is zero. The account is down 25%: 100 becomes 150, then 75.
That gap between arithmetic and geometric returns is volatility drag. The more a return series swings, the more it costs, for the same average. Approximately, the geometric return equals the arithmetic mean minus half the variance.
For traders, the point is that smoothness has value. A strategy with a 2% monthly average and low volatility compounds better than one with a 2% average and high volatility. Reducing risk, even at the cost of slightly lower average return, can improve long-term growth.
It also explains why large position sizes hurt. Beyond some level, increasing risk reduces compounded growth despite increasing the average return. The optimal growth rate lies at a moderate level of risk, and exceeding it is a path to ruin.
A spreadsheet that compounds a series of monthly returns, then compares it with the simple sum, shows the effect.
A numerical example: two strategies each average 3% per month. Strategy A has a standard deviation of 2%, Strategy B 8%. Over a year, A grows by roughly 41%, while B grows by roughly 29%, using the approximation that the geometric return is the arithmetic mean minus half the variance. Same average, very different outcomes.
How much does volatility drag cost on the trading account, comparing average monthly return with compounded growth?
That gap between arithmetic and geometric returns is volatility drag. The more a return series swings, the more it costs, for the same average. Approximately, the geometric return equals the arithmetic mean minus half the variance.
For traders, the point is that smoothness has value. A strategy with a 2% monthly average and low volatility compounds better than one with a 2% average and high volatility. Reducing risk, even at the cost of slightly lower average return, can improve long-term growth.
It also explains why large position sizes hurt. Beyond some level, increasing risk reduces compounded growth despite increasing the average return. The optimal growth rate lies at a moderate level of risk, and exceeding it is a path to ruin.
A spreadsheet that compounds a series of monthly returns, then compares it with the simple sum, shows the effect.
A numerical example: two strategies each average 3% per month. Strategy A has a standard deviation of 2%, Strategy B 8%. Over a year, A grows by roughly 41%, while B grows by roughly 29%, using the approximation that the geometric return is the arithmetic mean minus half the variance. Same average, very different outcomes.
How much does volatility drag cost on the trading account, comparing average monthly return with compounded growth?