A Simple Call That Created a Big Question
I received a call from a friend one evening. His voice was full of confusion and frustration. He said, "I don't understand this at all. Five years back, I invested ₹5 lakhs in equity and ₹5 lakhs in debt. My equity averaged 11% return per year. My debt averaged 9% per year."
He paused, then continued, almost angrily: But today, my equity portfolio value is less than my debt portfolio. If return is higher, corpus should be higher. That is basic maths, no? Less return asset is winning, and higher return asset is losing. How is this even possible?”
His confusion was genuine. And honestly, his logic was also very natural. This is exactly how most people think. Higher return percentage means higher money. Bigger number means better outcome. We think like this because this is how we are trained to think in school, in jobs, in salaries, in growth, in performance, in marks. Everything in life works on simple averages and comparisons.
So when someone sees 11 percent and 9 percent, the mind automatically concludes that 11 percent must create more wealth. There is nothing wrong in this thinking from a human point of view. But investing does not work on human intuition. Investing works on mathematical logic. And this is where the misunderstanding begins.
How Retail Investors Naturally Think: Arithmetic Mean Logic
Most retail investors unknowingly use what finance calls Arithmetic Mean, which is simply the normal average.
The number looks clean. The number looks logical. The number feels correct. So the mind says, “Return is return. Average is average. Higher average means better investment.” This is natural thinking. This is human thinking.
But this thinking breaks when money enters the picture.
Arithmetic Mean assumes that capital remains constant, growth is additive, gains and losses cancel each other, and time periods are independent. Money does not behave like that. In investing, capital changes every year, growth is multiplicative through compounding, losses damage the base capital, recovery is non-linear, and the sequence of returns matters.
A very simple example shows this clearly:
This is the first real mental break in investing logic.
Arithmetic Mean tells you what happened to the percentages, not what happened to your money. It averages numbers, but it ignores the changing capital base on which those numbers act. It treats gains and losses as if they cancel each other, even though in real life they do not.
A 50 percent gain and a 50 percent loss may cancel in arithmetic, but they do not cancel in wealth. The gain works on a smaller base, the loss works on a bigger base, and the result is capital destruction. This is why average returns can look harmless, while real wealth quietly disappears.
Why Numbers Add, But Wealth Multiplies
Returns behave like numbers. Wealth behaves like money. And there is a big difference between the two.
When we calculate averages, we add numbers and divide. This is additive thinking. It assumes gains and losses cancel each other. It works for marks, salaries, scores, and statistics. But money does not grow this way.
Wealth grows through multiplication, not addition. Every return acts on a changing capital base. This is compounding. This is why money follows a multiplicative path. A gain increases the base, a loss reduces the base, and every future return depends on this new base.
This creates another important effect. Profits and losses do not impact wealth equally. A loss hurts more than a gain helps. Recovery always needs more effort than the loss itself. This is why negative returns damage not just wealth, but also the ability of wealth to compound in the future.
This is the hidden mathematics behind volatility drag.
Additive Thinking vs Multiplicative Reality
|
Concept |
Additive (Average Thinking) |
Multiplicative (Wealth Reality) |
|
Growth logic |
Numbers are added |
Capital is multiplied |
|
Example |
+10% and −10% cancel |
+10% and −10% destroy wealth |
|
Calculation |
10 − 10 = 0 |
100 × 1.10 × 0.90 = 99 |
|
Result |
No change assumed |
Real wealth loss |
|
Meaning |
Percentages matter |
Capital base matters |
|
Explanation |
We think +10% and −10% cancel and we return to the same
base |
Start with 100 → +10% = 110 → −10% = 99 (not back to 100) |
From Return Thinking to Wealth Thinking
Once this understanding comes, a deeper question arises. If average return cannot tell me what happened to my capital, then what can? Now the focus shifts from returns to capital. Now the question is not “How much return did I get?” The question becomes “How did my money actually grow?”
This is where the concept of Geometric Mean enters. Geometric Mean asks a very different question: “If my money had grown at one steady rate every year, what rate would give me the same final wealth?” This is not return thinking. This is wealth thinking. This is compounding thinking.
Geometric Mean respects compounding, capital base change, loss impact, volatility and the sequence of returns. It shows real growth, not attractive percentages.
However, Geometric Mean has a practical problem. It is calculation heavy, data heavy, and not easy for normal investors to compute. It is not shown clearly on platforms, not visible in statements, and not discussed in simple investor conversations. So it remains academically correct but practically difficult.
CAGR: Making Compounding Usable for Normal Investors
This is why CAGR (Compound Annual Growth Rate) becomes important. CAGR is the practical investor form of Geometric Mean. It takes the same compounding logic and makes it usable.
CAGR asks one simple question: “From start to end, what constant annual growth rate explains this journey?” Geometric Mean is the theory of compounding. CAGR is the usable form of that theory.
Comparative Example: Same Capital, Same Period, Same Average Return – Different Wealth
|
Year |
Scenario 1: Stable |
Scenario 2: Small Variance |
Scenario 3: High Variance |
|
Annual
Returns |
9%, 9%,
9%, 9%, 9% |
12%, 6%,
10%, 7%, 10% |
20%,
−10%, 18%, −8%, 25% |
|
Year 1 |
5,00,000
× 1.09 = 5,45,000 |
5,00,000
× 1.12 = 5,60,000 |
5,00,000
× 1.20 = 6,00,000 |
|
Year 2 |
5,45,000 ×
1.09 = 5,94,050 |
5,60,000
× 1.06 = 5,93,600 |
6,00,000
× 0.90 = 5,40,000 |
|
Year 3 |
5,94,050
× 1.09 = 6,47,515 |
5,93,600
× 1.10 = 6,52,960 |
5,40,000
× 1.18 = 6,37,200 |
|
Year 4 |
6,47,515
× 1.09 = 7,05,791 |
6,52,960
× 1.07 = 6,98,667 |
6,37,200
× 0.92 = 5,86,224 |
|
Year 5 |
7,05,791
× 1.09 = 7,69,312 |
6,98,667
× 1.10 = 7,68,534 |
5,86,224
× 1.25 = 7,32,780 |
|
Arithmetic
Mean (AM) |
9% |
9% |
9% |
|
CAGR
(Compound Annual Growth Rate) |
9% |
8.98% |
7.95% |
 |
| The Investment Mindset Gap Return-Focused Retail vs Risk-Focused Institutional Investors |
Understanding Volatility Drag
All three portfolios started with the same capital. All three ran for the same time. All three even show the same average return of 9 percent. On paper, they look identical. But in reality, the final wealth is different. The only difference between them is how the returns behaved year after year.
The stable portfolio grows smoothly. There are no shocks, no falls, no recovery struggles. Compounding works efficiently, and wealth grows steadily. The small variance portfolio has mild ups and downs. Compounding still works, but a little efficiency is lost. The high variance portfolio has big ups and big downs. Every fall damages the capital base, and every recovery has to fight harder to rebuild that base. Compounding becomes inefficient, even though the average return remains the same.
This is the real meaning of volatility drag. Volatility does not change the average return, but it changes the final wealth.
Academically, this relationship is expressed as:
CAGR ≈ Average Return − (Variance / 2)
This relationship shows a simple but powerful truth: when variance increases, CAGR automatically comes down. Even if the average return looks attractive, higher fluctuations in returns reduce the efficiency of compounding.
In simple words, variance means how much returns move away from their average. The more returns swing up and down, the more the capital base gets disturbed, and the more compounding loses its smooth growth path. Losses damage capital more than gains rebuild it, and recovery always requires disproportionately higher returns. Over time, this reduces the effectiveness of compounding and lowers final wealth.
This is why two portfolios with the same average return can produce very different wealth outcomes. The difference is not return. The difference is return behaviour.
In simple language, volatility is a hidden tax on wealth creation.
The Hidden Double Impact of Losses
The Real Mindset Gap: Retail vs Institutional Thinking
This is where the real investment mindset gap appears. Retail investors and institutional investors operate with very different mental models.
Retail investors usually focus on visible returns. They look at percentages, past performance, recent winners, and headline numbers. They compare returns and choose what looks bigger. Their thinking stops at return comparison. Risk is seen as discomfort, not as a mathematical variable. Volatility is seen as temporary noise, not as a structural cost. Their core question is simple: “How much return did I get?”
Institutional investors think very differently. They focus on risk structure, drawdowns, capital preservation, volatility, correlation, compounding efficiency, and survival of capital. Their first question is not about return. Their first question is about risk: “How much can I lose, and how fast can I recover?” They understand that if capital survives, wealth grows. If capital breaks, returns do not matter.
Retail investors try to grow money fast. Institutional investors try to make sure money does not die.
A Simple Comparison of Mindsets: Retail Vs Institutional Investors
|
Retail Investor Focus |
Institutional Investor Focus |
Remarks |
|
Return
percentages |
Risk
structure |
Retail
looks at visible numbers, institutions look at hidden risk |
|
Past
performance |
Drawdown
control |
Retail
chases winners, institutions manage losses |
|
High
return assets |
Capital
preservation |
Retail
seeks growth, institutions ensure survival |
|
Market
stories |
Probability
and models |
Retail
follows narratives, institutions follow data |
|
Short-term
results |
Long-term
survival |
Retail
thinks in cycles, institutions think in decades |
|
Excitement
and momentum |
Stability
and consistency |
Retail
seeks action, institutions seek stability |
|
“How much
return?” |
“How much
risk?” |
Different
core questions define behaviour |
The Real Meaning of Wealth Creation
This article is not really about equity versus debt, or high returns versus low returns. It is about how people understand money. Retail investors are taught to chase returns, but never taught to understand risk. They learn how to compare percentages, but not how to read compounding. They see performance, but not structure. Institutions, on the other hand, do not worship returns. They design systems that protect capital, control volatility, and allow compounding to work quietly over time.
And that is the real investment mindset gap.
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