Standard Deviation

“Standard Deviation” is one commonly used measure of investment risk, measuring the historical volatility of an investment’s returns. More specifically, standard deviation measures the extent to which returns, monthly or quarterly mutual fund returns for example, are spread around the average return for a period of time. Standard deviation is typically considered for time periods of three years or greater. Standard deviations for shorter periods may be misleading, for typical investor analysis, since a single data point may significantly influence the result.

A larger standard deviation reflects larger historical volatility; and, a lower standard deviation reflects lower historical volatility.

For example, the two hypothetical funds below both averaged 18% (arithmetic average) for the five periods shown, but the Bumpy-Ride Fund’s returns varied more from period to period than did the Smooth–Sailing Fund. That increased variability, or “volatility risk,” is reflected in the higher standard deviation for Bumpy–Ride Fund of 14.8% compared to Smooth–Sailing Fund’s standard deviation of 2%.

Return Time PeriodsHypothetical Return Percentages
Bumpy-Ride FundSmooth-Sailing Fund
Year One 0% 19%
Year Two 20% 17%
Year Three 10% 21%
Year Four 40% 16%
Year Five 20% 17%
Average Annual Return
(arithmetic average)
18% 18%
Standard Deviation 14.8% 2%

The above example using these two hypothetical funds is meant to help explain the concept of standard deviation and does not suggest that a 14.8% standard deviation is high; nor, that a 2% standard deviation represents a low standard deviation target.

Standard deviation is only one of the tools used to measure investment risk. When used, standard deviation should be used as a relative measure to compare a specific fund versus its benchmark, peer group or other funds for the same time period. As in the example above, standard deviation may be used in conjunction with the fund’s performance to determine if the level of volatility is being rewarded by the fund’s performance.

Past volatility or performance is no indicator or guarantee of future results.

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