Variance drain (volatility drag) is the mathematical reality that higher volatility reduces compound growth, even if the average return stays the same. A portfolio with 10% average return and 20% volatility loses roughly 2 percentage points per year to this effect — a critical factor in long-horizon retirement projections.
Variance drain — also called volatility drag or volatility tax — is the phenomenon where higher volatility reduces the compound (geometric) growth rate of a portfolio, even when the arithmetic mean return is unchanged. It is a mathematical certainty, not a market anomaly.
How It Works
The relationship between arithmetic and geometric returns:
Geometric return ≈ Arithmetic return − (Volatility² / 2)
| Arithmetic Return | Volatility | Variance Drain | Geometric Return |
|---|---|---|---|
| 10% | 10% | 0.5% | ~9.5% |
| 10% | 15% | 1.1% | ~8.9% |
| 10% | 20% | 2.0% | ~8.0% |
| 10% | 30% | 4.5% | ~5.5% |
A simple example: a portfolio gains +50% then loses -50%. The arithmetic average return is 0%, but the portfolio ends at 75% of its starting value — a -13.4% geometric return. The volatility destroyed real wealth despite an "average" return of zero.
Why It Matters for Retirement Planning
Variance drain has two major implications for retirees:
-
Long-horizon compounding: over a 30-year retirement, even a 1-2% annual drag compounds dramatically. A portfolio that grows at 8% vs. 10% arithmetic return (due to variance drain) can end up 30-40% smaller after 30 years.
-
Monte Carlo simulation inputs: simulations must use arithmetic returns as inputs (not geometric) because the geometric compounding — including variance drain — happens naturally as returns are applied sequentially across iterations. Using geometric returns as inputs would double-count the drag.
This is also why diversification and asset allocation matter beyond reducing risk: by lowering portfolio volatility, they reduce variance drain and improve the compound growth rate — a benefit that is invisible in single-period return comparisons.
Frequently Asked Questions
- How much return does volatility actually cost?
- The approximation is: geometric return ≈ arithmetic return - (volatility² / 2). For a portfolio with 10% average return and 20% volatility, variance drain costs roughly 2 percentage points annually (0.20² / 2 = 0.02), reducing the compound growth rate from 10% to about 8%. Over a 30-year retirement, this compounds to a massive difference in terminal portfolio value.
- Can I reduce variance drain?
- Yes — by reducing portfolio volatility through diversification, asset allocation, and rebalancing. A diversified portfolio with 12% volatility loses only ~0.7% to variance drain versus ~2% for a concentrated portfolio with 20% volatility. This is one reason diversification improves long-term outcomes even if it doesn't increase average returns.