Track the companies that matter to you. It's FREE! Click one of these fan favorites to get started: Apple; Google; Ford.



Your Returns Are Less Than Average

My Foolish colleague and lead analyst for Motley Fool Income Investor, Mathew Emmert, has the following quote from Hank Blaustein on his Foolish profile page:

"What have I learned in life? I have learned this: If you are down by 70%, then up by 70%, you have NOT broken even."

The math behind that statement is simple enough. Start out with $100, lose 70% ($70), and you're left with $30. Then, off the new base of $30, gain 70% ($21), and you're only back to $51. That's an extremely painful investing lesson to learn -- just ask anyone who purchased General Electric (NYSE: GE  ) in early 2000.

Just how painful is volatility?
On a recent trip, I had a good 16 hours of travel time to kill, so I flipped through Just One Thing, a collection of investor insights edited by John Mauldin. I recommend it for any investor. A chapter by Ed Easterling, titled "Risk is Not a Knob," has a great discussion on volatility and all of its potential evils -- remember, volatility is your friend when it makes prices low and allows you to buy.

The book includes a table of sample portfolios similar the one below. Each sample portfolio earned an average return of 10%, but the more variable the annual returns, the lower the actual returns to the investor. It makes a good case for tracking not just annual returns but total compounded returns. (That is, if you aren't doing so already.)

Portfolio 1

Portfolio 2

Portfolio 3

Portfolio 4

Year 1 Return





Year 2 Return





Year 3 Return





Year 4 Return















Beginning Value





Ending Value





You can see the same effect by taking individual stocks, calculating their average growth rates, then figuring out their compound annual growth rates. I did this for former tech titans Microsoft (Nasdaq: MSFT  ) and Cisco (Nasdaq: CSCO  ) and found that they returned an average of 9.56% and -2.66%, respectively, over the past five years. However, on a compound basis, Microsoft returned 7.03% per year, while Cisco delivered -12.46% per year. This shows a fair amount of volatility in both companies, but a great deal more in Cisco.

So here's the logical question: Is it possible to contain volatility and still earn the rewards one expects from investing in stocks?

Smooth out your returns
Volatility is simply part of the investing game, though I prefer to have less of it in my portfolio. To do so, first I focus on dividend-paying companies with consistent earnings, such as Johnson & Johnson (NYSE: JNJ  ) and Factset Research Systems (NYSE: FDS  ) .

Next, I estimate the company's future cash flows and discount them to present value. Finally, I use the data to make sure I'm not overpaying for a company's prospects.

This is the strategy I apply to approximately 80% of my portfolio, leaving me with the freedom to buy yet-unproven growth companies that I think will pay a dividend in the future. But I'm still looking for cash, even among these young firms. Companies such as Coach (NYSE: COH  ) and MSC Industrial Direct (NYSE: MSM  ) fit this bill.

Foolish final thoughts
Volatility is your friend when you're looking to purchase shares, but it kills returns in your portfolio. And while we can't eliminate volatility altogether, it can be reduced by focusing on companies that pay dividends -- or at least generate lots of cash.

To date, Mathew's Income Investor picks are beating the market by nearly four percentage points and doing it with less volatility. To get a sneak peak at the most recent issue, all the previous picks, and our subscriber-specific discussion boards, take a free 30-day trial.

NathanParmelee owns shares in Microsoft and Johnson & Johnson, but has no financial interest in any of the other companies mentioned. Microsoft is a Motley Fool Inside Value pick. The Motley Fool has adisclosure policy.

Read/Post Comments (0) | Recommend This Article (0)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

Be the first one to comment on this article.

Sponsored Links

Leaked: Apple's Next Smart Device
(Warning, it may shock you)
The secret is out... experts are predicting 458 million of these types of devices will be sold per year. 1 hyper-growth company stands to rake in maximum profit - and it's NOT Apple. Show me Apple's new smart gizmo!

DocumentId: 502650, ~/Articles/ArticleHandler.aspx, 10/13/2015 1:03:15 PM

Report This Comment

Use this area to report a comment that you believe is in violation of the community guidelines. Our team will review the entry and take any appropriate action.

Sending report...

Nate Parmelee

Today's Market

updated Moments ago Sponsored by:
DOW 17,136.70 4.84 0.03%
S&P 500 2,013.70 -3.76 -0.19%
NASD 4,836.86 -1.78 -0.04%

Create My Watchlist

Go to My Watchlist

You don't seem to be following any stocks yet!

Better investing starts with a watchlist. Now you can create a personalized watchlist and get immediate access to the personalized information you need to make successful investing decisions.

Data delayed up to 5 minutes

Related Tickers

10/13/2015 12:43 PM
COH $30.96 Up +0.13 +0.42%
Coach CAPS Rating: ****
CSCO $27.93 Down -0.04 -0.13%
Cisco Systems CAPS Rating: ****
FDS $164.05 Down -0.21 -0.13%
FactSet Research S… CAPS Rating: ***
GE $28.14 Up +0.05 +0.19%
General Electric C… CAPS Rating: ****
JNJ $96.18 Up +0.19 +0.20%
Johnson & Johnson CAPS Rating: ****
MSFT $47.02 Up +0.02 +0.05%
Microsoft CAPS Rating: ***
MSM $63.18 Down -0.78 -1.21%
MSC Industrial Dir… CAPS Rating: ****