Portfolio Returns & Volatility: Historical Relationship Explained

Imagine you’re at a crossroads deciding between two paths. One path is smooth, predictable, and leads to a steady but perhaps modest reward. Think of it like a reliable savings account. The other path is rocky, winding, and uncertain, but it hints at the possibility of a much greater payoff. This is similar to the choice investors face when considering different investment strategies, especially when it comes to building large, diversified portfolios.

Historically, the data strongly suggests a direct link between the average return you can expect and the volatility, often measured as standard deviation, you’ll have to endure in a diversified portfolio. Let’s break down what this means in simpler terms.

Think of ‘return’ as the profit you make on your investments over time. It’s the growth of your money, like the fruits of your labor. ‘Volatility’, on the other hand, is a measure of how much the value of your investments goes up and down. It’s the degree of uncertainty and fluctuation. A highly volatile investment is like a rollercoaster – it can give you thrilling highs and stomach-dropping lows. Standard deviation is simply a way to quantify this volatility; a higher standard deviation means more price swings, more ups and downs.

Now, when we talk about ‘large, diversified portfolios’, we’re referring to collections of many different investments spread across various asset classes, like stocks, bonds, and real estate. Diversification is like not putting all your eggs in one basket. If one investment performs poorly, others might do well, helping to cushion the overall impact and reduce risk compared to investing in just a single asset.

So, what does history tell us about the relationship between average returns and volatility for these diversified portfolios? The historical data shows a clear trend: portfolios that have delivered higher average returns over the long run have generally also experienced higher volatility. Conversely, portfolios with lower volatility have tended to offer lower average returns.

You might wonder, why is this the case? It boils down to a fundamental principle of finance: the risk-return tradeoff. Investors are generally risk-averse, meaning they prefer less risk if all else is equal. To entice investors to take on more risk, there needs to be a potential reward. This reward comes in the form of higher expected returns.

Think of it like this: if you want to climb a taller mountain to get a better view, you’ll likely face a steeper, more challenging, and potentially more dangerous climb. The easier, safer trails usually lead to lower viewpoints. In the investment world, assets and strategies with the potential for higher returns are often considered riskier because their prices are more likely to fluctuate significantly.

For example, historically, stocks, particularly those of smaller companies or companies in emerging markets, have offered higher average returns than government bonds. However, stocks are also known to be more volatile. Government bonds, on the other hand, are generally considered less risky and less volatile, but their average returns have typically been lower.

This relationship isn’t a perfect guarantee in every single year, of course. Markets are complex, and short-term fluctuations can occur. However, over long periods, the historical evidence consistently points to this positive correlation between average return and volatility for diversified portfolios. If you want to aim for potentially higher long-term returns in your investment portfolio, history suggests you should be prepared to accept a higher degree of volatility along the way. It’s a balancing act, and understanding this relationship is key to making informed investment decisions.