How much returns vary through time

How much and how often the returns vary is often described as 'volatility'.

The word 'risk' is also used to describe volatility. At MLC, we believe investors are usually more concerned about the risk of not achieving their financial goals. To some people risk may mean the possibility of losing some of their initial investment. For others, it may be the risk of their assets not producing the income they anticipate. And for yet others, it may mean the risk of not having sufficient wealth to fund a desired lifestyle.

Your financial adviser can help you develop a strategy to achieve your financial goals, considering issues such as:

• the return you need from your investment
• how comfortable you are with your investment value rising and falling
• how many years you will be investing for
• your financial position
• whether you need to draw down or receive an income from your investment

While the idea of volatility can be confronting, without it you may not get the returns you need to reach your financial goals.

The amount of volatility varies between asset classes as illustrated.

Growth assets, such as shares and property securities, usually have more volatility because many factors can cause their value to change. But we also expect they will generally produce a higher return than other asset classes in the long-run.

Defensive assets, such as debt securities and cash, generally have lower volatility as their values usually don't change by large amounts. Cash and other low risk investments generally provide a lower return over the long term, but are unlikely to lead to a capital loss if held to maturity.

As markets and investor sentiment are unpredictable, especially over short periods of time, asset classes won't always perform this way.

In fact, it can take a whole market cycle for asset classes to perform in line with expectations. Each market cycle includes the depths of a weak market and the subsequent peak of a strong market. A market cycle can take a couple of years or many, many years. It's different each time. That's why you need to be prepared for all sorts of return outcomes when investing.

To give you a feel for potential volatility, the graph below shows the range of annual returns – the highest to the lowest - that some of the main asset classes experienced over the last 109 years.

You can see Australian shares had the largest range, and is therefore expected to have the highest volatility, with cash having the lowest.

The middle point in the range of returns is also shown as a dotted line. The lowest middle point is in the asset class with the smallest range of returns - cash. And the highest middle point is in the asset class with the widest range – Australian shares.

In general, the higher the degree of volatility associated with an investment, the higher the return that will be required by investors to accept the volatility. This is often described as the risk/return tradeoff.

While looking at one-year returns may be interesting, most of us invest for much longer than one year. In fact we usually invest for many decades; even after we retire. So let's take a look at 10-year returns, using the same scale as the above graph.

As you can see, the returns are more volatile over one-year periods than 10-year periods. Over longer periods of time, the different returns offset one another and the 10 year returns show less volatility. Although the volatility is still present over shorter periods, the longer the period you measure your returns over, the less volatility they demonstrate.

While it's not always easy to ignore what is happening to your investment each day, month or year, you should expect to face volatility over short periods of time but continue to focus on your progress towards your long-term goals. After all, it's your long-term goals that matter.

Investors lose by chasing performance

Many investors struggle to outperform the market, and chasing performance is one of the most common investment mistakes. A 2007 study by Dalbar – a Boston-based market research firm – compared returns from the US share market to those achieved by the average investor over the previous 20 years.
The study found that the US stock market as measured by the S&P 500 Index returned an average of 11.8% pa over this period – effectively turning a $100,000 investment into around $930,000. By contrast, the average investor (who invariably tried to pick winners by using past performance as a guide) received only 4.3% pa or just over $230,000 in dollar terms. By chasing performance, investors effectively missed out on around 7.5% pa, or an extra $700,000 growth on their original $100,000 investment.