Volatility and Return: Stocks vs. Portfolios

Imagine you are deciding what to invest your money in. You might think, naturally, that if you take on more risk, you should expect to earn a higher return. This makes intuitive sense in many areas of life. If you climb a taller mountain, you face more risk of falling, but you also get a better view at the top. In the world of investing, this idea connects to volatility, which we can think of as how much the price of an investment jumps around. A highly volatile stock is like a rollercoaster, with big ups and downs, while a less volatile stock is more like a slow-moving train.

Now, let’s consider individual stocks. Think about a small, relatively unknown company. Its stock price might be very volatile. Perhaps they are developing a new technology, and if it succeeds, the stock price could skyrocket. But if it fails, the stock could plummet. This is high volatility driven by the specific ups and downs of that single company, what we often call company-specific risk or idiosyncratic risk. You might be tempted to think that because this stock is so volatile, it must offer a very high average return to compensate for that risk. However, this is often not the case. Many individual volatile stocks actually have surprisingly low average returns, or even negative average returns. Think of it like buying a lottery ticket. The potential payoff is huge and the price is small, making it very volatile in terms of potential outcomes. But the expected return, the average return if you bought many lottery tickets over time, is actually quite low, much lower than the volatility would suggest. This is because the volatility of an individual stock is often driven by factors unique to that company, things that can be diversified away.

Now, shift your focus to large portfolios, like a mutual fund that holds hundreds of different stocks across various industries. When you build a portfolio like this, something interesting happens. The company-specific risks, those ups and downs unique to individual companies, start to cancel each other out. If one company has a bad day due to a product recall, another company in a different sector might have a great day because of a new product launch. This process of diversification significantly reduces the overall volatility of the portfolio. The rollercoaster ride becomes much smoother. However, what remains after diversification is the risk that affects the entire market, often called market risk or systematic risk. This is the risk related to broad economic factors like interest rates, inflation, and overall economic growth. You can’t diversify this type of risk away because it impacts almost all companies to some extent.

For large, diversified portfolios, the relationship between volatility and average return looks quite different. Because the company-specific noise has been reduced, the volatility that remains in a well-diversified portfolio is primarily systematic risk. And this type of risk is indeed related to expected return. Investors generally demand a higher average return for taking on more systematic risk. Think of it like this: if the entire economic climate is uncertain, and all businesses are facing potential headwinds, investors will want to be compensated for investing in the market as a whole. Therefore, portfolios with higher systematic risk, which translates to higher overall portfolio volatility in a diversified context, tend to offer higher average returns over the long run. This is the core idea behind why diversification is so important. It allows you to reduce the “bad” type of volatility, the company-specific kind that doesn’t necessarily reward you with higher average returns, and focus on the “good” type of volatility, the systematic risk that is linked to higher expected returns in the market as a whole. So, while for individual stocks, volatility and average return can seem loosely connected or even disconnected, for large, diversified portfolios, there is a much clearer and more positive relationship between volatility and the average return you can expect.