A standard deviation in investing is a measure of volatility regarding investment returns. The larger the standard deviation, the wider the range of returns tends to be. In contrast, an investment with a small standard deviation tends to have more consistent returns.
Let’s look in more detail at what a standard deviation means for investors.
Definition and Examples of a Standard Deviation in Investing
The term “standard deviation” can be used in many areas of statistics and can involve some complex mathematics. For investing purposes, you can think of standard deviation as simply a volatility metric. The standard deviation essentially tells you how much investment returns tend to deviate from the average.
For example, you might see that a stock or a mutual fund has returned an average of 10% over the past 10 years. But that doesn’t necessarily mean that every year the asset returned exactly 10%. That’s where the standard deviation comes in.
If the asset has a standard deviation of, say, 5%, then most of the time the returns would be expected to deviate from that 10% average between plus or minus 5%. So, from 10%, you may commonly see 5% to 15% returns as well under the standard deviation. If the standard deviation was 15%, then the asset would be expected to have more volatility, as returns on an asset averaging 10% in this case could also commonly range from -5% to 25%.
That’s not to say that the returns can’t fall outside of a standard deviation range. For example, if the standard deviation was 5%, then a 10% swing from the average would be considered two standard deviations. As you’ll learn below in more detail, the majority of returns fall within one standard deviation.
How a Standard Deviation in Investing Works
A standard deviation in investing works by measuring how much returns tend to stray from the average. If the standard deviation is zero, then the asset would provide the same returns without varying from year to year.
In reality, however, there’s often a range of returns, so the standard deviation provides a measure of how much volatility exists.
Standard deviations generally follow a statistical rule, known as the empirical rule or the 68-95-99.7 rule. For investing, this rule means that:
- 68% of the time: returns falls within one standard deviation
- 95% of the time: returns fall within two standard deviations
- 99.7% of the time: returns fall within three standard deviations
In all but the most extreme cases, investment returns fall within three standard deviations. And more often than not, they fall within one standard deviation.
An asset’s stated standard deviation percentage reflects one standard deviation. So, using an example of an asset that has average annual returns of 10% with a standard deviation of 5%, that means that one standard deviation is 5%, two standard deviations equals 10%, and three standard deviations is 15%. For this asset:
- 68% of the time: returns fall between 5% and 15%
- 95% of the time: returns fall between 0% and 20%
- 99.7% of the time: returns fall between -5% and 25%
Now suppose that there’s a standard deviation of 20% for an asset that has average annual returns of 20%. That would indicate much higher volatility, where even though the average returns are higher, investors might go through much more dramatic swings. In this example:
- 68% of the time: returns fall between 0% and 40%
- 95% of the time: returns fall between -20% and 60%
- 99.7% of the time: returns fall between -40% and 80%
What a Standard Deviation in Investing Means for Individuals
Understanding standard deviations can help investors make investment decisions that align with their risk tolerance and overall financial circumstances.
Some investors might not be comfortable investing in assets that have such high volatility, even if the potential reward is greater. Retirees, for example, might prefer more reliable returns to fund their retirement lifestyle, rather than potentially navigating periods where assets return far less than average.
Some investors might be comfortable accepting more volatility if it means potentially higher returns in the long run. Still, you might prefer to know what you’re getting into in terms of standard deviations, rather than getting caught by surprise if returns swing up and down.
Keep in mind, however, that standard volatility might not be the only risk measure to look at, nor is it necessarily a direct proxy for risk.
To find this metric, you might be able to turn to some financial services firms that publish their own standard deviation numbers. In other cases, determining standard deviations on your own might involve complex math, so you may want to work with a professional if you want to calculate these figures.
- A standard deviation in investing is a measure of volatility.
- Assets that have a higher standard deviation tend to provide a wider range of returns than those with lower standard deviations.
- Knowing the standard deviation of an asset can potentially help investors make better risk/reward decisions.
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