No pain, no gain.

If you can't stand the heat, stay out of the kitchen.

Just suck it up.

I could go on with the tough guy homilies but you probably get the idea. That's how we're supposed to respond to market downturns. The tougher we are, the more volatility we can take, and the more we will be rewarded. Exalted returns may require extreme levels of pain.

Nice idea, but completely devoid of truth.

The reality is that smooth returns win. Volatile returns lose. The more volatile your return, the harder it will be for you to have a good long term return. At its worst, statistical types even have a gruesome phrase for what happens: variance sink.

You can understand with a simple demonstration. Suppose you invest $1,000 and get a steady return of 10 percent a year for five years. Each year your interest will be added to our original principal and you'll earn a return on your return. Do it long enough and you'll be like the couple in F. Scott Fitzgerald's novel, The Great Gatsby, who lived on "the interest on their interest."

In five years your $1,000 grows to $1,611. Check the following table:

Stable 10 Percent Growth

Year Return Amount

1

10.0%

$1,100

2

10.0%

$1,210

3

10.0%

$1,331

4

10.0%

$1,464

5

10.0%

$1,611

Avg. Return=

10.0%

12.2%

Source: Scott Burns's calculations

Now let's look at three 'swing for the fences' investments, one that starts well, one that doesn't, and one that has four good years and one bad year. All three have average returns of 10 percent a year. But all three grow to less at the end of five years than a Steady Eddy 10 percent return. Indeed, our first investment doubles in the first year, only to drop 50 percent in the second year, rise 10 percent in the third, and drop 10 percent in the fourth. After a fifth year at 0 percent return, it ends up with $990.

In other words, while the return averaged 10 percent, we actually lost money over the five-year period.

Three Volatile Investments

Year Return 1 Amount Return 2 Amount Return 3 Amount

1

100.0%

$2,000

-50.0%

$500

25.0%

$1,250

2

-50.0%

$1,000

100.0%

$1,000

25.0%

$1,563

3

10.0%

$1,100

0.0%

$1,000

-50.0%

$781

4

-10.0%

$990

0.0%

$1,000

25.0%

$977

5

0.0%

$990

0.0%

$1,000

25.0%

$1,221

Avg. Return=

10.0%

-0.2%

10.0%

0.0%

10.0%

4.4%

Source: Scott Burns's calculations

Finally, let's take a really extreme example--- something like an Internet investment from last year. You invest $1,000 and immediately lose 90 percent. Even though your returns range from 50 to 20 percent over the next four years and your average return is 10 percent, you end up with only $328, a loss of 67 percent.

If the variation in your returns is really wild, a single bad return can set you so far back that you never recover. Statisticians call it "variance sink." A population biologist would call it "extinction."

Drowning in the Variance Sink

Year Return Amount

1

-90.0%

$100

2

50.0%

$150

3

40.0%

$210

4

30.0%

$273

5

20.0%

$328

Avg. Return=

10.0%

-13.4%

Source: Scott Burns's calculations

What this means for you and me as investors is that the more we do to smooth out the return on our investments, the greater the odds we will enjoy handsome long term compounding. This is the exact opposite of what has been happening in the investment world during the last three years:

• We had individuals shifting from relatively diversified portfolios of fixed income and equities to virtually all equity portfolios.

• We had individuals shifting from mutual funds to individual stock portfolios, even as stock volatility increased.

• We had mutual funds offering "concentrated" portfolios. Some concentrated on particular sectors, some just concentrated on a limited number of stocks. Either way, volatility increased.

Small wonder so many people were so badly mauled as stock prices plunged.

So we might have to rewrite some of those macho homilies for investing.

How about, "No pain, big gains."