You and your buddy both have $100,000 to invest for two years. You talk strategy but differing opinions on risk cause you to take separate strategies. After deciding to take the more conservative route, you invest your 100k and earn 10% in year one. Your buddy takes a riskier route with his money and earns 20% in the first year. He then makes fun of you endlessly.
In year two, you continue to earn 10%, but your friend’s risky strategy makes nothing.
Over the course of two years you both averaged 10% per year [(10%+10%)/2=10% and (20%+0%)/2=10%], BUT your account balance reads $121,000 and his is $120,000. Who is laughing now?
In part two we will look at why this happens (hint- the answer lies in volatility).