Most investors spend their lives chasing returns, better picks, hotter funds, and the next IPO poised for a moonshot. It’s understandable since returns are posted everywhere and brag-worthy over holiday dinners. Risk, by contrast, is abstract and not as easily reduced to a number.
I operate from a simple belief, forged over my three decades in the market: the way we make money over the long term is by not losing too much in the short term. It’s not a complicated idea. Benjamin Graham said something similar seventy years ago.
I’ve written before about the three levers that drive long-term wealth: returns, time, and contributions. But there’s a prior question that underpins all three: What happens when losses interrupt the base amount? The math, as it turns out, is more damaging than most investors realize. And yet, most portfolios are still built backwards: optimizing for returns with risk as an afterthought, even though the math argues it should be exactly the reverse.
Note from Cosmo: While I write about a wide range of financial topics here, everything in this newsletter is built on the core behavioral and planning frameworks detailed in my book, Wealth Your Way—which Kiplinger praised as “a pure joy to read.” Grab your copy on Amazon here to explore the full blueprint.
The number that actually matters
Let me give you a simple example: Two portfolios with the same average return and the same starting investment of $100,000.
Portfolio A returns 10% every single year. Boring and predictable. Portfolio B jumps around, up 30% one year, down 10% the next, alternating indefinitely. More exciting, but the same simple average of 10%.
After 20 years, Portfolio A has grown to approximately $673,000. Portfolio B, with the same 10% average return, has grown to just $481,000. That’s a $192,000 difference. Poof. It wasn’t bad picks or bad luck draining the pot, but rather return volatility. Most investors think of capital preservation as playing defense, but the math says it’s a compounding strategy in its own right.
The confusion stems from something called the geometric (compound) average. It’s the actual compound growth rate of your money, as opposed to the simple average of your annual returns. Think of it this way. A simple average treats every year equally. The compound average, however, weighs losses more heavily, because losses do more damage than equivalent gains can repair.
Start with $100. Lose 50%, and you're down to $50. Then double your money with a 100% gain. Your simple average return is 25%. Your balance? Back to $100. Your compound average is zero. The simple average lied.
Portfolio B’s simple average return is 10%, but its actual compound average is only 8.17%. That 1.83% gap doesn’t sound like much, but just like mutual fund expenses, it adds up.
Channeling his mentor, Benjamin Graham, Warren Buffett once said that the first rule of investing is to not lose money. The second rule is to not forget rule #1. Lose 10%, and you need an 11.1% gain to get back to even. Lose 30%, and you need a 42.9% gain to recover. Lose 50%? A 100% gain only gets you back to square one. Your portfolio balance just doesn’t care about your feelings or your simple average.
The permanent impact of “temporary” losses
Tennis great Roger Federer won 80% of the matches he ever played, but he won barely more than half (54%) of the individual points. His match percentage and point percentage tell completely different stories. So do average returns and compound returns.
Most investors treat losses as temporary inconveniences that they hopefully will bounce back from. What they don’t see, however, is what happens in the meantime.
Every down year doesn’t just cost you the loss. It costs you the base on which your compounding would have grown. Your money isn’t growing during recovery; it’s just getting back to where it was. A loss is a detour where you end up driving the same miles twice.
In our alternating-return example, the negative 10% years force the subsequent +30% years to spend half their energy on recovery rather than growth. Over 20 years in our example, that drag costs you 1.83% annually in real compounding. And as we saw, it’s a six-figure bill.
Smooth, lower returns often beat volatile, higher average returns. The math isn’t quirky. On the contrary, it’s ruthlessly precise.
The father of Modern Portfolio Theory knew this too, and couldn’t stop it
The framework that still governs most portfolios today was questioned by its own creator within a decade of its publication. That’s the part nobody talks about.
In 1952, Harry Markowitz published Modern Portfolio Theory, arguably one of the most influential frameworks in the history of finance. It introduced the idea of mean-variance optimization: evaluate portfolios by their expected return and their volatility. It was elegant and mathematically beautiful. All built around the simple average, not the compound average, which is why MPT would judge our Portfolios A and B as equally valid choices.
By 1959, just seven years later, Markowitz was already exploring the compound average as the more meaningful measure of long-term portfolio growth. By 1976, he was emphatic about it.
But it was too late. MPT had already become the foundation of academic finance. It gave birth to the Capital Asset Pricing Model. It had been institutionalized across investment practices worldwide. An entire ecosystem of regulation and portfolio construction had been built on its simple-average framework.
This is how paradigms work. The first framework to gain traction becomes the last one standing because everything gets built on top of it. The paradigm had locked in, and the wrong metric had won. This also explains why hospitals still send faxes!
What this means for your portfolio
This background isn’t just an interesting footnote in financial history because it has direct consequences for how most portfolios are constructed today, and for how most investors think about risk.
MPT’s framework led to optimizing around simple average returns while quietly underperforming in actual compound growth. Think of it as a volatility tax: the hidden drag that volatile portfolios pay on their compound returns. The model looks optimized, while your ending balance tells a different story.
A big loss hurts at any stage. But the closer you are to drawing from your portfolio, the less time you have to recover, and the more damaging the timing becomes. It doesn’t matter when the loss occurs. The ripples spread out, and near retirement, they can become waves.
In Retirement Planning, Consider the Entire Journey
The fragile decade is the wonderfully exhilarating time that spans the last five years of working and the first five years of retirement. It’s also the period that could blow up your whole retirement plan.
The practical takeaway isn’t to avoid all risk. That’s a whole different mistake. It’s to recognize that protecting capital isn’t the conservative choice, but rather the compounding choice.
You can compound your way out of a hole, but it takes longer. Recovery will restore the number, but it doesn’t restore the trajectory. In our example, that cost is $192,000. In yours, it could be far more.
Manage risk first. If you find yourself in a hole—stop reaching for the shovel. Portfolio growth will follow.
As always, invest often and wisely. Thank you for reading.
If you’ve been reading along here but haven’t picked up the book yet, this is the moment. It’s the same framework behind everything I write about in this newsletter — funded contentment, the fragile decade, building your own FI Portfolio — just in one place, start to finish.
“A pure joy to read… like sitting across the table for a chat over coffee.” — Kiplinger
The content provided is for informational and educational purposes only. It does not constitute legal, tax, investment, financial, or other advice. You are welcome to share, quote, or use the content — including for research or machine learning — please credit Cosmo P. DeStefano and link to www.CosmoDeStefano.com. Originally published at www.CosmoDeStefano.com.
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This is really interesting. Is the compound average of a given fund or ETF something that is available or do we have to calculate it ourselves if we are interested?
This is an awesome article. I guess the next step is to talk about how to reflect this into actual practice. Presumably via appropriate diversification and rebalancing? It is also worth noting that modern modeling tools incorporate these notions using Monte-Carlo and/or Historic (back-testing) mechanisms.
I would quibble with the comparison to Faxes. Faxes are still in use because the of technology concerns more than "paradigm" considerations. The Fax technology was in place long before more modern alternatives and these alternatives are still not quite as complete and/or universal in some domains such as health care.