Investing and volatility. This example illustrates how volatility can eat into your returns, even when you have a high yearly average return. Although the numbers may be more extreme than you would likely see in a real investing situation, the situations illustrate why volatility can hurt your investments.
(a) Suppose you invest $1,000 for 40 years at an effective interest rate of 7%. Calculate how much you will have after 40 years.
(b) Suppose you invest $1,000 for 40 years. For the first year, you return 50%. For the second year, you have a return of -36%. Every other year, you alternate between +50% and -36%. How much will you have after 40 years?
(c) What is the average return in a given year in each case?