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.
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.
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.
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.