MINI CASE 7.1

When you say that an investment like a stock market index fund has an expected return of 9 per cent, you are saying that in any year there is a chance that your return will be better than 9 per cent and a chance that it will be worse. To get more specific about your chances, you need to specify the expected volatility of the investment, as well as its expected return. The volatility of an investment is given by the statistical measure known as the standard deviation of the return rate. You don't need to know the exact definition of standard deviation to understand this article, although the definition is in the glossary if you really want to know it. You can just think

of standard deviation as being synonymous with volatility...a standard deviation of zero would mean an investment has a return rate that never varies, like a bank account paying compound interest at a guaranteed rate.

Here the calculator has been initialized with returns that correspond to a portfolio of 100 per cent stocks during your working years and a 60/40 mix of stocks and cash during retirement. This little calculator shows you where the numbers come from (and it also shows you our assumptions about return rates).

The wildcard here is the 19 per cent return for stocks. Expert opinion varies on expected future returns for the stock market: you will find estimates that are much lower than that and others that are much higher. Here the 19 per cent is equal to the average return of the FTSE All Share Index from 2005 through the first quarter of 2011, which includes some good years and some bad years.