Volatility and your Time Horizon

The volatility of an investment is measured by the standard deviation of its rate of return.

(If your statistics is a little rusty, you can think of the standard deviation as measuring how far away from the average the return rate for any one year is likely to be. The greater the standard deviation, the more variable the rate of return.)

This interactive graph shows how expected returns and expected fluctuations affect the likely outcomes of your investment. The graph uses a random process, so there is uncertainty built into the result - just like life! You choose an investment with a specified return and volatility, and the graph will produce a bell curve of possible outcomes.

The area of the "negative return zone", shown in red, is proportional to the probability that you will lose money on your investment.



    % Ave Return
    % Std Dev

Time Horizon

 1 year
 5 years
10 years
20 years


Here are some things you should try:

  • Set the time horizon to 5 years, and compare the results for the Stocks and Bonds portfolios. You'll find that the Stocks graph lies to the right of the Bonds graph, as you'd expect (the expected return is higher) but the "red zone" for Stocks is also larger. This is the classic risk/reward tradeoff. If two identical groups of people invested in portfolios like these, the average gain of the Stocks group would be greater than that of the Bonds group, but the Stocks group would have a larger number of investors who actually lost money.

  • Now try the Stocks portfolio with different time horizons. You'll find that the "red zone" decreases as the time horizon grows. This is why investment books always tell you that volatile investments may be appropriate if you don't plan to withdraw the money for decades; but if you're planning to start taking it out within the next few years, you should consider switching to a more stable portfolio, even if that means settling for a lower expected rate of return.

  • Try Stocks with a time horizon of 1 year. Now the graph doesn't look like a bell at all: over this short a time frame the stock market is "really" random, more like a game of chance than an investment.

This type of calculator is known as a Monte Carlo simulation, or MCS: that means it calculates many possible outcomes, to show you both your expected return and the risk that you'll do worse than that.

Next: how diversification reduces volatility.

Article Contents
MPT Introduction
Volatility and Time
Efficient Frontier
Sharpe Ratio
Build a Portfolio
Index Investing
CAPM, Beta
Alpha, R-Squared
Three Factor Model
Insurance Analogy
Books & Links

Article Contents
Index Funds Article
CAPM Calculator
Market Simulator


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