Let's take a focused look at the concept of variance drain and the impact it can have on even a well-managed investment portfolio. The following parable, based very loosely on an actual event, is designed to drive home the important point that controlling portfolio volatility not only makes investors more comfortable, but actually grows wealth faster than more volatile portfolios with the same—or even higher—returns.
Dick and Jane and Variance Drain
Dick and Jane are twins. In case you're wondering, the answer is yes, they have a sister, Sally, and a dog named Spot. For many years they lived a cheery middle-class life. Dick would throw a stick and Spot would chase after it.
“Look, Dick, look!” Jane would say. “See Spot run!”
“Run, Spot, run!” said Dick.
All this came to an abrupt end on their twenty-first birthday, however, for on that day they received an inheritance from Weird Uncle Fred. Uncle Fred had immigrated to Switzerland many years ago, and his legacy was, like Fred, weird.
According to the Swiss trust officer, Uncle Fred had left each of them $1 million. However, the money was in trust and neither principal nor interest would be paid out until their thirty-first birthday. (This meant that the money could compound tax-free.)
But there was a further provision. Uncle Fred considered himself to be a great investor, and he wanted Dick and Jane to become great investors, too. Therefore, said the trust officer, a gnome-like gentleman, at the end of 10 years the ...