In a previous post on measurements of risk in mutual fund research, we focused on the use of concepts such as beta, sharpe ratio and standard deviation as tools to evaluate the risk of a mutual fund. Standard deviation is probably the most common measure of a mutual fund’s risk, and is worth a closer look. Like most things, if used without a proper understanding, it can be misleading and worthless; but if used correctly it can be of significant value in helping you make better investment choices.

Standard deviation quantifies how much the returns of a fund vary around their mean, or average. In this way, standard deviation provides a precise measure of how varied a fund’s returns have been over a particular time frame. The higher the standard deviation of a fund, the more varied or volatile its returns have been.

Here’s an important example which highlights what this means in practice: a mutual fund that gained 1% each and every month over the past 36 months would have a standard deviation of zero, because its monthly returns never changed from one month to the next. But a mutual fund that lost 1% each month would also have a standard deviation of zero - again, its returns didn’t vary. Meanwhile, a fund that gained 7% one month, 20% the next, and that lost 8% the next would have a much higher standard deviation; its returns have been more varied.

As you can see from this example, there are a few critical things to note about standard deviation:

●      A fund with a low standard deviation doesn’t necessarily mean the fund has performed positively. Although funds with a low standard deviation tend to lose less money over short time frames than those with high standard deviations, the measure of standard deviation itself is not an indicator of strong positive performance. Look at it as a volatility measure, rather than a performance measure.

●      Standard deviation is an absolute measure which is not compared with other funds or with a benchmark. A standard deviation of 7 for a fund is obviously higher than a standard deviation of 5, but what does that mean for that fund? Are these high or low figures? Because a fund’s standard deviation is not a relative measure, it’s not very useful to you without some context.

So, how do we correctly use standard deviation?  Firstly, to help determine if your fund’s standard deviation is high or low, we suggest you look at the standard deviations of similar funds – those in the same category as the fund you’re examining. If you are evaluating a mid-cap growth fund, then look at the standard deviations of other funds in the mid-cap growth category to get a sense of what looks high or low. Or if your fund is a large-cap value fund, then measure its standard deviation against funds in the large cap value category. Also look to major indices as benchmarks for  standard deviation: the S&P 500 for equities funds, Barclays aggregate for bond funds, and MSCI EM for emerging markets funds.

And, of course, always look at standard deviation in conjunction with other performance factors such as return. This is particularly useful when looking at funds with comparable returns. For instance, if you have two funds that have an annual return of 10% and if fund A has a standard deviation of 3.4 and fund B has a standard deviation of 6.5, then fund B is more risky or volatile. Both funds have similar returns but fund B is less predictable than Fund A. In such cases, we should prefer fund A since its returns are comparable to fund B and are much more predictable.

It’s important to note that high standard deviation is not a bad thing per se. Generally, you need to take on more volatility to earn higher potential returns over the long term. What you want for any particular kind of risk asset is the lowest possible risk (standard deviation) for the return levels you seek. For More Information Please Visit: www.jemstep.com