What is Standard Deviation? – Meaning, Formula & Uses

Mutual funds often promise attractive returns, but the path to those numbers usually takes a lot of work. High potential returns are tempting, but you must also be aware of the danger involved with these types of investments. Here, Standard Deviation is of great use. Financial experts frequently speak of standard deviation in terms of its value as a measure of risk, and it can provide important information that explains the way to smarter investment choices.

Would you like to explore how standard deviation is calculated in this scenario?  Let’s dive deeper into this statistical tool and understand how it can be your compass in the world of mutual funds.

Meaning Of Standard Deviation

In the domain of investment, particularly investing in mutual funds, the emphasis is mostly on the gains as opposed to the possible losses. This article has thus established an understanding of the volatility of a rather undeniable aspect of investments known as returns. Standard deviation is a powerful statistical instrument in this process.

In other words, standard deviation is a statistic that counts the variation or spread of the values of a data set around the arithmetic mean. In simpler terms, it is the means used to determine the variability of a set of data. When applied to investments, it becomes a gauge of volatility, how much a fund’s returns can swing from its average return over a specific period.

How Does The Standard Deviation Work?

Standard deviation is like a measure of how spread out numbers are in a dataset. It tells you how much the data points typically differ from the average (mean). Imagine a group of students whose heights vary. Some are tall, some are short, and most are somewhere in between.

• Calculate the average height: This is the mean.
• Measure how far each student is from the average: This is the deviation.
• Standard deviation: This is like the “average” of these deviations.

Let’s break down the standard deviation with a mutual fund example. Imagine a mutual fund scheme boasting an average return of 15% and a standard deviation of 5%. This means:

• The fund’s returns typically fluctuate around 15%: This is the average performance.
• The standard deviation of 5% indicates the extent of this fluctuation: In simpler terms, the fund’s actual returns can fall within a range of 10% to 20%.
• A fund with a low standard deviation over a period of 3-5 years generally suggests greater consistency in returns. The fund’s performance has been relatively stable, with fewer extreme ups and downs. This characteristic might appeal to investors who prioritize capital preservation and steady returns over the potential for high but volatile gains.

Significance Of Standard Deviation:

Standard deviation in finance measures the volatility or risk of an investment. A higher standard deviation indicates greater price fluctuations, implying a riskier investment with potentially higher returns. Conversely, a lower standard deviation suggests a more stable investment with typically lower returns. It’s a key tool for comparing investment options, building diversified portfolios, and assessing investment performance.

Standard deviation is like the spread of popcorn kernels in a bag. If they’re all clustered together near the bottom, the standard deviation is low (a safer investment). But if they’re scattered everywhere, the standard deviation is high (a riskier investment).

How Is It Used?

Standard deviation is a common and important statistic that is used in the act of evaluating volatility in mutual funds, which is the degree of fluctuation or extent of divergence of returns on the fund from the average return over a given time period. Indeed, it quantifies the degree of volatility you can expect in the fund. A fund having a more significant standard deviation can have its returns fluctuate more wildly, which implies a higher level of risk but also a more substantial potential gain. 

On the other hand, a more minor standard deviation indicates reduced risk and more steady, consistent results. When comparing a fund’s risk profile to an investor’s risk tolerance and investing goals, this indicator can be beneficial.

Points To Focus 

• Imagine a mutual fund with an average return of 15%. While this is an appealing figure, standard deviation measures how much the fund’s actual returns might deviate from this average. A higher standard deviation signifies greater volatility; the returns can fluctuate significantly. Conversely, a lower standard deviation indicates more stability, with returns hovering closer to the average.
• While standard deviation is a valuable metric, it shouldn’t be the sole factor driving your investment decisions. A comprehensive risk assessment requires considering other metrics like:
• Sharpe Ratio: Evaluates risk-adjusted performance, considering both returns and volatility.
• Beta: Measures a fund’s volatility relative to the overall market.
• Alpha: Captures the excess return a fund generates compared to its benchmark.

Analyzing these metrics alongside standard deviation can paint a more complete picture of what fund’s risk profile.

• The timeframe plays a crucial role when interpreting standard deviation. Short-term data may not accurately reflect the fund’s total risk level, as can be observed over the long run. Calculating the standard deviation over several years gives more accurate information about the fund’s risk level in the past.
• Investing as a process is individualistic. To prevent high risk one should look for mutual funds that have a smaller standard deviation since it reflects those funds that are more stable in their volatility. On the same note, there are those market investors who are willing to invest on high risks, in order to have even higher returns, they can invest in the funds with the higher standard deviations.

Winding Up Thoughts!

Standard deviation is among an investor’s most essential and vital measures. It presents an alternative measure of risk since it enables investors to evaluate the variability of their investments. Nevertheless, it should be applied only in combination with other factors, and one has to recall that it is a statistical measure. Thus, knowledge of the standard deviation and using it in working with investments will allow for better investment decisions and, therefore, more effective risk management. 

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Disclaimer – This article is for educational purposes only and does not intend to substitute expert guidance. Mutual fund investments are subject to market risks. Please read the scheme-related document carefully before investing.