Advanced Diploma of Financial Planning (ADFP) Practice Test

What is one reason why equity funds historically earn higher returns over a long-term horizon?

1. Lower risk of loss compared to bonds

2. Greater volatility leading to higher potential gains

3. Investment in fixed income securities

4. Involvement in diversified portfolios

The correct answer is: Greater volatility leading to higher potential gains

One reason why equity funds tend to earn higher returns over a long-term horizon is due to their greater volatility, which can lead to higher potential gains. Equities represent ownership in companies, and their prices fluctuate based on various factors including company performance, market conditions, and economic indicators. This volatility, while presenting risks, also provides opportunities for significant growth. Over extended periods, equities have historically outperformed other asset classes, like fixed income, because they tend to reflect the underlying growth of the economy and companies. The higher returns associated with equities can be attributed to their ability to leverage economic growth and innovation, which can drive company profits and, in turn, stock prices upwards. While the potential for losses exists, the long-term upward trajectory of the stock market allows patient investors to benefit from those periods of volatility, leading to substantial gains over time. The other choices focus on risk comparison with other asset types or fixed income investments, and diversification, which are important considerations but don't directly encapsulate the specific reason why volatility in equity investments can lead to enhanced returns over a long-term horizon.