Why volatility matters

A major benefit of the KISS strategy is that since it is based almost solely on dividend return, the volatility of the return is very low. The volatility matters as it lowers the real compound return rate for investment. For example, an investment giving +100% return for the first year followed by a -50% drop the second year has average return of 25% but the real compound return is 0% (0.5·1.5=1). This is why the SP500 that has average annual return of 3.5% (adjusted for inflation and not counting dividends) has rewarded long term investors by a more modest 1.7% compound annual growth rate (CAGR).

For income investors, the volatility is even more detrimental: Consider a stock price drop of -50% that requires price rise of 100% just to make up the losses. But if the investor is using the 4% rule and sells 8% of his remaining stocks at the bottom to generate cash, the stock now has the rise 118% to get back to the starting point. This is a tall mountain to climb!

A stock market crash during the first few years of retirement is one of the biggest risks for those that follow the index investment approach to retirement. This risk is largely avoided by KISS investors that base their income on dividends and not on selling the stocks.

The compound annual growth rate CAGR is approximately related to the average return rAVE by 

compound annual growth rate (CAGR) vs average annual growth rate formula
For example, for SP500 the average return is rAVE = 3.5% and the standard deviation is σ = 19% giving average compound rate of

matching the historical data above.

Using Equation (1), we can estimate the largest acceptable standard deviation that will not seriously affect the CAGR. Table 1 shows the CAGR with constant rAVE = 10% and different volatilities. As the table shows, the large volatility seriously affects the real compounded return. A conservative investors should aim at standard deviations less than 10%.

Table 1: CAGR decreases with increasing volatity.