A Holistic View of Investment Volatility

Why the volatility of an individual investment does not tell the whole story

When markets become unsettled, volatility is often treated as synonymous with risk. Investors may look at an asset class experiencing larger price movements and conclude that it is inherently too risky for their portfolio.

But this can be misleading.

An investment’s volatility needs to be considered in the context of the portfolio as a whole. How an asset behaves relative to the other investments it is combined with, can be just as important as how much its own price fluctuates.

Measuring volatility

One of the most commonly used measures of investment volatility is standard deviation. It measures how widely an investment’s returns have historically varied around their average. A higher standard deviation indicates greater variability in returns, while a lower figure indicates that returns have tended to fluctuate less.

For example, Dimensional’s analysis shows that between January 1999 and June 2026, global small-cap stocks had an annualised standard deviation of 13.67%, compared with 11.63% for global large-cap stocks.

The analysis uses the MSCI World Small Cap Index and MSCI World Index, with returns measured in Australian dollars. Global small-cap and large-cap annualised standard deviation, January 1999 to June 2026. Source: Dimensional. Past performance is not a guarantee of future results.

At first glance, the figures might suggest that small-cap stocks are inherently more risky. But looking at these numbers in isolation misses an important part of the equation.

Portfolio risk is more than the sum of its parts

The volatility of a portfolio depends not only on the volatility of its individual holdings, but also on how those holdings move relative to one another.

This is where correlation becomes important.

If two investments tend to move in exactly the same direction at the same time, combining them may provide limited diversification. If they behave differently, however, the movements of one investment can partially offset movements in another.

In technical terms, portfolio variance incorporates both the variance of individual assets and the covariance between them. For a simple two-asset portfolio:

Portfolio variance = (weight₁² × variance₁) + (weight₂² × variance₂) + 2 × weight₁ × weight₂ × covariance₁₂

This illustrates why simply comparing the standard deviation of individual investments does not provide a complete picture of portfolio risk.

Why higher volatility does not automatically mean higher portfolio risk

Small-cap companies have historically experienced greater individual return variability than large-cap companies. However, small-cap stocks can behave differently from large-cap stocks over time.

When combined, this difference in behaviour can provide a diversification benefit. Dimensional’s analysis found that the overall standard deviation of a portfolio combining large and small-cap stocks can remain similar to that of large-cap stocks alone, even as the allocation to small-cap stocks increases. At the same time, returns increased meaningfully as the weight allocated to small caps increased over the period examined.

The important lesson is not that small-cap stocks are automatically better, or that investors should seek higher volatility.

It is that an asset cannot be properly assessed by its volatility in isolation.

A principle that goes back decades

The idea of evaluating investments in the context of a portfolio is not new.

Harry Markowitz’s Modern Portfolio Theory, developed in the 1950s, established the importance of considering how investments interact when constructing portfolios.

Rather than simply selecting investments based on their individual risk and return characteristics, the framework considers how different combinations of assets can produce different overall risk and return outcomes.

This creates an important distinction between stand-alone risk and an investment’s contribution to portfolio risk.

An investment may be relatively volatile on its own but still make a valuable contribution to a diversified portfolio if its returns are not perfectly correlated with other holdings.

Looking beyond the volatility number

This becomes particularly relevant during periods of market uncertainty.

It can be tempting to sell investments that have recently experienced larger price movements and move towards assets that appear more stable. But short-term volatility does not necessarily determine whether an investment is appropriate for a long-term portfolio.

Instead, investors should consider:

• How does this investment interact with the rest of the portfolio?
• What is its correlation with other holdings?
• What contribution does it make to expected returns?
• How might the overall portfolio behave in different market environments?
• Does the portfolio remain aligned with the investor’s objectives and time horizon?

These questions provide a more complete picture of risk than looking at a single volatility statistic.

Taking a holistic view

Diversification is not simply about owning more investments. It is about combining exposures with different characteristics and behaviours.

It also does not eliminate the possibility of loss. Markets can fall, correlations can change and diversified portfolios can still experience significant volatility.

The objective is instead to understand how individual investments contribute to the risk and return characteristics of the portfolio as a whole.

At Pyrmont Wealth, we believe investment decisions should be considered within the context of an investor’s wider financial objectives. Looking beyond individual volatility measures can help investors make more informed decisions and avoid judging an investment without considering the role it plays within the broader portfolio.

The most useful question may not be “How volatile is this investment?” but “How does this investment contribute to my portfolio?”

Source: Dimensional, “A Holistic View of Volatility”, September 2026. The examples above are for educational purposes only. Past performance is not a guarantee of future results. Investments can fall as well as rise and investors may not get back the amount originally invested.