Financial planners often talk about a risky investment or a conservative investment, but sometimes we need to stop and define these terms.
A risky investment is one in which, historically, the day-to-day price volatility has been high. A more conservative investment would be one in which the range between the highs and lows is much more narrow.
We tend to associate higher returns with the more aggressive investments, the ones with more volatility. One would assume higher risk equals higher reward. But it’s important to point out that the risk factor can also mean lower returns, or even losses.
When discussing market risk, I like to point to the following example, which shows how volatility can be risky:
Let’s say you had invested $10,000 in each of two mutual funds 20 years ago, and that both funds produced average annual returns of 10 percent. However, one, we’ll call Steady Freddy, returned exactly 10 percent every year. The other fund, we’ll call Jekyll and Hyde, alternated, yielding 5% one year, 15% the next, and so on for 20 years.
In each case, the average annual return was 10%. But, at the end of the two decades, the Steady Freddy fund had yielded $2,000 more than the Jekyll and Hyde fund. This is a direct effect of investment price volatility. Short-term fluctuations in returns are a drag on long-term growth. The moral of the story is that it’s important to look at average volatility as well as average rate of return.*
All of this underscores the importance of asset allocation. A diversified portfolio is a guard against the possible negative effects of volatility.
*This is a hypothetical example and does not reflect the performance of any specific investment. This example assumes the reinvestment of all earnings and does not consider taxes or transaction costs.
Investments are subject to risk, including the loss of principal. Because investment return and principal value fluctuate, shares may be worth more or less than their original value. Some investments are not suitable for all investors, and there is no guarantee that any investing goal will be met. Past performance is no guarantee of future results. Talk to your financial advisor before making any investing decisions.