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As an investor, you may have a number of goals (e.g., retirement, big purchase, education). There are many different ways to reach those goals. It will help you make better investment decisions if you understand the relationship between volatility and returns and find a balance that works for you.

Volatility is defined as the price movement of an investment. The more the price changes, the greater the volatility. For example, an investment whose price shifts between +7% and -5% in one year is more volatile than an investment whose return fluctuates between +3% and -2% over a year.

One way to think about it is preparing for weather on vacation. Suppose 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.

All investments, even cash, include some level of volatility. In general, cash is not very volatile while some stocks, or equities, can be quite volatile.

Here's an example of where the three primary asset classes fall on the potential volatility and return spectrum. Notice that higher returns tend to go hand-in-hand with higher volatility.

Cash
usually held in short-term money market or T-bill investments
Fixed income
typically refers to bonds or credit issued by governments or corporations
Equity
refers to shares of publicly traded companies
Expected return dial-set-to-low dial-set-to-medium dial-set-to-high
Expected volatility dial-set-to-low dial-set-to-medium dial-set-to-high

Historically, the Canadian stock market* has risen more often than it has fallen.

Rolling 1-, 3-, 5-, 10-, 20- and 30-year periods from January 1, 1980 to December 2018

Key Points

  • Historically, the Canadian stock market* has risen much more often than it has fallen.
  • Since 1980, the Canadian stock market has not posted a negative 10-yr rolling return.
  • Stock markets have historically trended upward.
Historically, the Canadian stock market delivered positive returns in nearly 72% of all rolling one-year periods since 1980. When the timeline is extended, the Canadian market has never posted a single negative return during any 10, 20, 30-year rolling period since 1980. When it comes to investing in stocks, it's all about time. The longer your investment time horizon, the greater the likelihood that you may benefit from the growth potential of stocks. Since January 1, 1980, an all-Canadian equity portfolio would have delivered an average annualized return of 8.4%

Volatility of a diversified portfolio decreases over time

Rolling 1-, 3-, 5-, 10-, 20- and 30-year average annual returns from January 1980 to December 2018

Key Points

  • Volatility has historically been higher over shorter periods.
  • Over longer periods of time, the impact of volatility becomes less noticeable.
  • Investors have historically been rewarded for staying invested.
In the short term, portfolio returns can vary quite significantly since the value of investments changes daily. This fluctuation is known as volatility. For example, since 1980, 1-year rolling returns for a globally diversified portfolio of stocks and bonds have ranged from -25% to +64% - a difference of 89%. Time tends to reduce the impact of volatility. Over any 30-year rolling period since 1980, the maximum average annualized return on a diversified portfolio has been 11% compared with the minimum average annualized return on the same portfolio of 7% - a difference of only 4%. Although including stocks in your portfolio may result in increased volatility relative to investments that don't include equity, over long periods of time, the impact of these fluctuations tends to decline. Historically, a diversified portfolio has delivered solid long-term absolute returns.

Illustrative only and not predictive of future results. Rolling periods are periods of consecutive months with new periods beginning on the first day of each month. For example, the first 1-year period began January 1, 1980 through to Dec 31, 1980.

Source: RBC GAM

*Canadian Stock market represented by S&P/TSX Composite Total Return Index.

Index returns are compounded annually and assume reinvestment of all distributions but do not reflect deduction of expenses associated with investments. If such expenses were reflected, returns would be lower. An investment cannot be made directly in an index.

Asset class alone does not determine the volatility of an investment. For example, within fixed income, some types of bonds may be more volatile than others. To learn more, read our article on How to diversify in fixed income.

Consider the ride

It’s common for investors to focus solely on a fund’s historical return when choosing funds for their portfolio. However, it is also 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.

Understanding the relationship between volatility and returns- crt-risk-time-graph

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 with risk, time horizon and long-term goals.

When markets are volatile, you may find yourself experiencing risk in a very different way. In addition to your comfort level with risk, your financial ability to take on risk – your risk capacity – is an important consideration.

Take our risk capacity quiz

Disclosure

This 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. RBC GAM takes reasonable steps to provide up-to-date, accurate and reliable information, and believes the information to be so when provided. Information obtained from third parties is believed to be reliable but RBC GAM and its affiliates assume no responsibility for any errors or omissions or for any loss or damage suffered. RBC GAM reserves the right at any time and without notice to change, amend or cease publication of the information.