Yesterday I mentioned that it looks like volatility is ahead. You might think that volatility isn't so bad as long as prices are generally headed higher, right?

Well, sort of. If prices are headed generally higher then your portfolio's value is increasing. As they say, all boats rise with the tide. Even the bad news tends to be forgotten or overlooked when you're making money.

The unfortunate thing about market volatility is that it erodes returns. Let's look at a theoretical example of a stock that repeatedly rises 10% and then falls 10%.

The average return on this investment is 0%; but the end result is an erosion in the value of the investment. This is the harsh truth of mathematics. Ten percent of a larger number is more than ten percent of a smaller one. You lose more money on a ten percent drop in a higher priced security than you gain on a ten percent rise in a lower priced stock.

The same holds true for a smaller amount of volatility, say, when prices fluctuate only 5%:

If only the markets would move in a nice straight line... Life would be so much easier.

Ah, but far less interesting.