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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

10%

7%

6%

23%

Year 2 Return

10%

4%

9%

-9%

Year 3 Return

10%

12%

4%

0%

Year 4 Return

10%

17%

21%

26%

Average

10.00%

10.00%

10.00%

10.00%

CAGR

10.00%

9.89%

9.81%

8.98%

Beginning Value

\$10,000.00

\$10,000.00

\$10,000.00

\$10,000.00

Ending Value

\$14,641.00

\$14,582.13

\$14,539.55

\$14,103.18

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?

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.

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Nate Parmelee
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