Standard Deviation of Returns: Understanding the Volatility and Risk in Investments
Investing can be a daunting task for many people. With so many investment options available, it’s difficult to know which ones will provide the best returns. One way investors gauge their potential return on an investment is through the use of standard deviation.
Standard deviation refers to the measure of how much an investment’s returns vary from its expected value. In other words, it measures volatility or risk in investments. The higher the standard deviation, the more volatile and risky an investment is considered to be.
Understanding Standard Deviation
To understand standard deviation, we first need to understand variance. Variance is a statistical term that measures how far each number in a set of data is from their mean or average value squared. It represents how widely spread out the data points are.
Standard deviation is simply the square root of variance. Instead of measuring distance in units squared like variance does, standard deviation measures distance in units – usually dollars – like your initial investment.
Here’s an example: Suppose you’re considering investing $10,000 into two mutual funds: Fund A and Fund B. You look at both funds’ historical returns over five years and find that:
Fund A has earned annualized returns of 8%, with a standard deviation of 5%.
Fund B has earned annualized returns of 8%, with a standard deviation of 15%.
The difference between these two mutual funds is their level of risk as measured by their respective standard deviations.
While both funds have identical average returns (8%), Fund B has three times greater volatility than Fund A due to its higher-standard deviation score (15% versus 5%). This means there’s more variability around its average performance compared with Fund A’s less variable performance.
Why Does Standard Deviation Matter?
Standard deviation matters because it helps investors assess whether they’re comfortable taking on additional risk for potentially higher rewards or not. The higher the standard deviation, the more volatile and risky an investment is.
Investors who are looking for stable returns with minimal risk may prefer investments with low standard deviations. However, investors who are willing to take on more risk may seek out high-standard deviation investments in hopes of earning larger returns.
It’s essential to note that while a high-standard deviation can lead to potentially higher rewards, it also means there’s greater potential for significant losses. This is why it’s critical to understand your tolerance for risk before making any investment decisions.
How Standard Deviation Impacts Portfolios
Standard deviation not only impacts individual investments but also entire portfolios. Diversification involves investing in various assets across different industries or sectors to minimize risk. A well-diversified portfolio typically has lower volatility than one that isn’t diversified since you’re spreading your risks across multiple investments.
Here’s an example: Suppose you have $100,000 that you want to invest in stocks and bonds. You decide to put 80% ($80,000) into stocks and 20% ($20,000) into bonds. You then choose five different stocks:
Stock A has a standard deviation of 10%
Stock B has a standard deviation of 15%
Stock C has a standard deviation of 5%
Stock D has a standard deviation of 20%
Stock E has a standard deviation of 25%
You also choose two different bond funds:
Bond Fund F with a standard deviation of 2%.
Bond Fund G with a standard deviation of 1%.
The overall portfolio’s average return will depend on how much each stock or bond contributes (i.e., its weight), but what we’re interested in here is how much the portfolio fluctuates around its expected value.
By combining these seven securities together based on their respective weights, you’d end up with an overall portfolio whose weighted-average return is about +12%. By calculating this multi-asset approach using standard deviation, the portfolio’s volatility (as measured by standard deviation) is about 12%.
As you can see from this example, diversification helps to reduce overall risk. Stocks with higher-standard deviations are offset by bonds with lower-standard deviations, resulting in a less volatile portfolio.
How Standard Deviation Affects Investment Strategy
Investors should consider their investment strategy when deciding how much importance to place on standard deviation. For example, investors who are long-term focused may not be as concerned about short-term fluctuations or high standard deviations since they’re more interested in long-term growth over time.
In comparison, short-term traders or those investing for shorter periods may need to focus more on minimizing risk and volatility since they don’t have as much time to recover from significant losses.
Furthermore, different types of investments will have varying levels of standard deviation. For instance:
Stocks tend to have higher-standard deviations than bonds because stocks represent ownership in companies that can fluctuate depending on market conditions and other factors.
International stocks tend to have higher-standard deviations than domestic stocks due to currency fluctuations and economic policies that differ between countries.
Commodities such as gold or oil tend also to have high-standard deviation scores because the prices of these assets can vary widely based on supply and demand factors like geopolitical events or weather patterns.
Real estate investments trusts (REITs) tend also to have low-to-moderate standardized-deviation scores since they typically provide steady income via rent payments instead of rapid capital appreciation seen in faster-moving stock markets.
Conclusion
Standard deviation provides a measure of an investment’s risk/volatility compared against its expected return. Investors use the metric when evaluating potential investments and building diversified portfolios across various asset classes ranging from stocks and bonds through commodities like gold/oil all the way down into real estate options such as REITs. It has become one of many tools used by analysts worldwide thanks primarily due diligence efforts performed before making any decisions about their investments.
Investors should be aware of the risk they are willing to take on and seek professional advice if needed. By incorporating standard deviation into investment decisions, investors can make more informed choices when allocating their capital across a diverse range of assets with different levels of risk/volatility.