A Risk-Based Framework for Stabilizing the Investment Journey
“The first rule of compounding is to never interrupt compounding unnecessarily.” — Charlie Munger
In theory, this sounds simple. In practice, it is anything but. Volatility targeting and compounding are deeply connected because investor behavior—rather than weak long-term returns—most often disrupts compounding during periods of market volatility.
Volatility, Investor Behavior, and the Compounding Process
Equity markets generate returns through a path that alternates between calm and turbulence. Long stretches of stability can suddenly give way to sharp drawdowns, large daily swings, and periods dominated by uncertainty and headlines. These episodes are not merely unpleasant — they are consequential.
Because investors do not experience long-run averages. They experience daily outcomes. And those daily outcomes shape behavior.
When markets become volatile, discipline erodes. Investors who intended to remain committed to a long-term investment plan may begin behaving like short-term traders. Allocations are reduced and subsequently frozen following losses — precisely when maintaining exposure is most critical. In extreme cases, investment plans are abandoned altogether.
The failure mode is rarely the market’s long-term return. It is the behavioral response to short-term volatility.
Once behavior becomes reactive, compounding becomes fragile.
Conversely, extended rallies and unusually calm markets can distort risk perception in the opposite direction. Investors may feel more tolerant of risk, increase exposure, and concentrate positions late in the cycle. Again, it is not expected return that changes dramatically — it is perceived risk.
Why Volatility Targeting Focuses on Risk, Not Returns
This behavioral dynamic provides the motivation for volatility targeting.
The objective is not to forecast returns. It is to stabilize the investor experience.
Volatility exhibits persistence. Periods of elevated volatility tend to be followed by further turbulence. Periods of calm often persist as well. Unlike returns, which are notoriously difficult to predict, risk displays predictability.
This persistence allows investors to adjust exposure systematically, reducing it when forecasted volatility rises and increasing it when volatility subsides, with the objective of keeping portfolio risk close to a predefined target over time.
A more stable risk profile translates into a smoother journey. And a smoother journey reduces the likelihood that stress regimes trigger pro-cyclical decisions that interfere with a long-term investment plan.
In this sense, volatility targeting directly controls risk exposure and shapes the investor experience through a disciplined risk-management overlay.
Because sometimes, protecting compounding is less about maximizing returns — and more about preventing unnecessary interruptions.
This article is adapted from the introduction of a forthcoming research paper co-authored with Prof. Antonio Mele and Prof. Walter Distaso . The paper examines volatility targeting in depth, introduces major classes of volatility forecasting models, and provides empirical evidence on their effectiveness and relative performance.
Stay tuned.
