A basic principle of finance and investing is that there is a tradeoff between the amount of risk you take and your expected return on investment. The more risk you take, the higher your expected return should be.
Both risk and expected return can be measured using historical data. For example, at the end of 2012, the 20-year average annual return of the S&P 500 stock index which represents the stock prices of 500 of the largest publicly trades companies in the United States was 8.22 percent. Therefore, you might reasonably conclude that if you were to invest in a mutual fund, or other type of fund, which replicates the return of the S&P 500, and you plan on holding that investment for 20 years, you might expect to earn an annualized return of about 8.22 percent. But that number alone doesn’t provide you with much insight into the amount of risk you are taking. If you had invested in stocks in 2001, and sold stocks in 2008, you would have concluded that investing in stocks is very risky. The amount by which investment returns vary over a certain time period is known as “volatility.” Volatility is a measure of risk. In this article we’ll discuss how to use measures of expected return and volatility to make smart financial decisions.
They say that timing is everything. If it were possible to consistently time financial markets there would be no reasons to talk about expected return and volatility. You could simply use market volatility to buy low and sell high, and sell high and buy low. However, there are very few, if any, people who can do that successfully over the long term. For most of us, a better approach to investing is to manage risk and return by measuring them over an investment horizon. In other words, don’t try to time markets, but rather identify an expected return and risk over a specific time horizon
For example, as measured by the volatility of their returns, stocks might be considered a risky investment. While the S&P 500 has returned 8.22 percent annually over the last 20 years, the annual returns have varied greatly, with 14 up years and six down years, including a positive return of 38 percent in 1995 and negative return of 38 percent in 2008. On the other hand, the variability of returns on fixed-rate investments such as one-year treasury bills has been low, but the return is also relative to the S&P 500.
Expected return and volatility must be considered together to make savvy financial decisions. For example, most investors look only at historical return numbers when deciding in which mutual fund to invest, but what if two mutual funds have nearly identical returns over a five-year period; should you be indifferent as to which fund you choose? The answer is no. Look at the volatility of the returns of each. You don’t need to be a statistician to do so, simply look at a graph, chart or table of each to determine which fund has the greatest variability in returns from year to year. The more variability in the returns, the more risk the fund manager is taking to generate returns, and the greater the probability that you will end up selling at a point in time when the price is low.
Your time horizon is an important factor in using expected return and volatility; the longer your time horizon, the more volatility in returns that you should be willing to accept. For example, if you are saving to purchase a home, and you expect to make that purchase one year from now, it would be inappropriate to invest your savings in stocks. The stock market is volatile. The next year might be a repeat of 2008. Even though stocks offer a higher expected return than a money market fund or CD, a wise choice would be to choose the lower volatility and return of a CD or money market fund. On the other hand, if you’re 35 years old and saving for retirement, you have plenty of time to ride-out price swings in stocks. It would be wise to choose an investment with high expected returns and price volatility since your investment horizon is several years.
In conclusion, next time someone tries to tell you that their fund is outperforming your choice of funds, ask them what the volatility of returns is for their fund and what their investment horizon is. You might able to tell than that your fund offers similar returns with less volatility, or that you have a specific time horizon in mind that doesn’t justify taking on the risk of added price volatility.
Barry Nielsen is mortgage secondary marketing officer at American Federal Savings Bank