We have already discussed the concept of investment volatility and compared two investments with different average returns. Let's revisit volatility but this time we will add a new caveat... we will compare investments with the same average return.
Here are three hypothetical investments, each with a 10% average annual return. Which would you choose?
Did you choose C? Most (risk tolerant) people do. After all, seven of the fifteen years are 15% gains or more and there are only three years with a loss. If you invested $100,000 in C you would have approximately $357,000. Not bad but you would have made $27,000 more if you chose B and a whopping $59,747 more if you chose A! Don't believe me? Here is the breakdown.
Remember, the average return on all three investments is 10% so we also need a measurement of the volatility. That measurement is standard deviation. The higher the standard deviation, the more volatile the investment. The standard deviation of A is 2%, B is 12%, and C is 16%. When the anticipated returns are the same, it is best to chose the lowest volatility. Consistency of portfolio performance over time generally provides better long term performance than more volatile portfolios despite the same average annual return.
Now for the lawyer talk... This is a hypothetical illustration and is not indicative of any particular investment.
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