Jargon-busting: Volatility

Jargon-busting: Volatility

The investment industry is fraught with technical terms, acronyms and jargon. For most investors, much is of little use and can overcomplicate or confuse discussions. This series of short notes touches on some commonly used - and commonly misunderstood – issues to help investors gain a greater understanding of the investment world, and bust through the investment jargon.

This note defines the concept of volatility. Other terms/abbreviations for the phenomenon include ‘vol’, standard deviation, and ‘risk’. In essence, a higher reading relates to a choppier investment journey over shorter time periods. Typically, the difference between ‘lower risk’ and ‘higher risk’ solutions is the latter tends to come with greater volatility – higher highs, and lower lows.

Volatility is stated as a percentage %. The figure can give useful context around how large interim performance swings can be. When volatility is ‘annualised’, as it often is, it refers to the movement of an investment when looking at performance on a full 12 month basis.

To use a volatility in practice one can use a simple rule of thumb. 1x volatility either side of the average return is expected to be experienced 2/3rds of the time, and twice the volatility either side of the average return 19 times out of 20. As a simple example, if the expected average annual return of a portfolio is 5% and the volatility is 10%, the returns over any 12 month period would be expected to be between -5% and +15% in two thirds of annual observations, and -15% to +25% in 19 out of 20 annual observations. This simple calculation gives a good idea of how choppy the investment journey is likely to be from year to year.

For context, a portfolio comprising 100% global developed equities¹ had a mean annual return of 10% between Oct-09 and Feb-23, with a volatility of 15%. The largest 12 month positive movement was over +50%, and the largest downward movement -20%.

Putting half of this portfolio into cash would result in the volatility and largest swings being halved, but also with half of the annual return. Part of selecting the most suitable investment solution is marrying up the expected interim movements that an investor can stomach with the long term goals of the invested savings.

¹ iShares Core MSCI World ETF USD Acc, priced in USD. Period used is since fund inception. Figures rounded for illustrative purposes. Source: Koyfin