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.
Here's an example of where the three primary asset classes fall on the potential volatility and return spectrum.
usually held in short-term money market or T-bill investments
typically refers to bonds or credit issued by governments or corporations
refers to shares of publicly traded companies
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
- 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.
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
- 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.
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.
There is a wide range of risk within the three primary asset classes. For example, in the fixed-income asset class, some types of bonds may be riskier than others.
Consider the ride
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.
Understanding types of risk
- Market risk comes from the volatility of rising and falling equity markets. There are a number of factors that can impact the markets, including economic performance, interest rates, political climate and industry or company developments.
- Interest rate risk primarily impacts interest-sensitive investments such as fixed income investments and bonds. This type of risk, which results from changing interest rates, typically concerns investors who rely on regular cash flow.
- Inflation risk can threaten long-term goals through the rising cost of goods and services. You can mitigate inflation risk and its effect on your long-term goals by including equities in your portfolio, which have historically outpaced inflation over time.
- Currency risk influences non-Canadian investments. Mutual funds that purchase foreign securities may be required to pay for securities using a foreign currency and receive a foreign currency when they sell them. Changes in the value of the Canadian dollar compared to foreign currencies will affect the value of any foreign securities in a mutual fund.
- Credit risk denotes a borrower's ability to repay a loan or obligation. Funds that invest in debt securities of companies or governments with higher credit risk tend to be more volatile in the short term. However, they may offer the potential of higher returns over the long term.
- Foreign investment risk represents the impact of global economic factors such as corporate information availability, accounting, auditing and reporting standards, trading volume on foreign markets and investment or exchange laws. Mutual funds that specialize in foreign investments may experience larger and more frequent price changes in the short term
To learn more about how to become a better investor, talk to your financial advisor.