Understanding the interaction between volatility and returns is a fundamental part of being a good investor. As you work toward your investing goals (e.g., retirement, big purchase, education), it is important to understand the relationship between the two and find a balance that works for you.
Generally, the more risk – sometimes referred to as volatility – you are willing to accept in your portfolio, the greater the potential returns.
Volatility is defined as the price movement of an investment. For example, if the price of an investment can potentially fluctuate between +7% and -5% within a year, it is more volatile than an investment whose return in any given year is expected to fluctuate between +3% and -2%.
Although all investments, even cash, include some level of volatility, the level varies depending on the type of investment. Generally, cash is not very volatile while some equities can be quite volatile. The chart on the right is an example of where the three primary asset classes fall on the potential volatility and return spectrum.
It’s common for investors to focus solely on a fund’s historical return when determining which funds they will use to build their portfolio. However, above and beyond looking at a fund’s five- or 10-year return, it is important to look at the volatility the fund experienced over that time period. Two funds with the same total return may have taken two very different journeys to get there.
For example, funds A and B have both returned 8% over the past 5 years. As you can see, these funds had similar long-term returns, but investors in fund A had to endure more ups and downs (volatility) to achieve the same end result.
Another way to think about it is preparing for weather on vacation. City A and City B both have average temperatures of 25 degrees in July. City A’s temperature sits at a balmy 25 degrees for most of the day, only slightly changing in the morning and evenings. So, because it has a lower temperature volatility, you only have to pack clothes appropriate for 25 degrees.
On the other hand, City B’s temperature – which also averages 25 degrees – peaks at 40 degrees mid-day and goes down to only five at night. Due to the higher temperature volatility you would have to pack everything from sweaters to multiple shirts a day, making the experience quite different.
Moral of the story is: returns are only one aspect of the investing experience. Think about the amount of volatility you can handle, and choose the fund that best meets your needs. Investors need to balance their expected returns with the anticipated volatility in their portfolio, keeping in mind their comfort level, time horizon and long-term goals.
This information has been provided by RBC Global Asset Management Inc. (RBC GAM) and is for informational purposes only. It is not intended to provide legal, accounting, tax, investment, financial or other advice and such information should not be relied upon for providing such advice. The information contained herein is from sources believed to be reliable, but accuracy cannot be guaranteed. Please consult your advisor and read the prospectus or Fund Facts document before investing. There may be commissions, trailing commissions, management fees and expenses associated with mutual fund investments. Mutual funds are not guaranteed, their values change frequently and past performance may not be repeated. RBC Funds, BlueBay Funds and PH&N Funds are offered by RBC Global Asset Management Inc. and distributed through authorized dealers.
® / ™ Trademark(s) of Royal Bank of Canada. Used under licence. © RBC Global Asset Management Inc. 2017
Investing and risk will always have a close relationship.