The mostly commonly used dimension of investment analysis is one everyone is familiar with: return on investment. This answers the question: “How much did I receive in compensation for the risk I took?” While determining return is usually straightforward, determining the quotient for risk is more ambiguous. If you missed our blog on the return dimension, you can read it here.
The second dimension of portfolio analysis is the quotient for risk most frequently used by the mutual fund industry: standard deviation. While numerous investment houses use standard deviation in their marketing materials, few investors and advisors actually know its definition. Standard deviation measures an investment’s dispersion of returns from its average return. In other words, it’s a measure of how widely scattered returns tend to be from the average return.
- If an investment has an average return of 6% and a standard deviation of 7%, it means about 68% of annual investment returns will be between -1% and 13% return.
- One standard deviation covers 68% of outcomes and two standard deviations covers 95% of outcomes.
- Taking a wider view, a person could say, “According to the mathematics, 95% of the time, the return should be between -8% and 20%.”
While standard deviation is a good general approximation of how widely returns can range from average, it is dangerous to use it to make probabilistic assessments. If used to answer the question “How much money might I lose if things go bad?” it will consistently understate risk by a large degree, to the detriment of investors. In conclusion, standard deviation answers the question “How much will my portfolio rise above or fall below the average return throughout normal market activity?” Yet, this is the primarily quotient the investment industry has been using for risk since the before the 1960’s.
Despite the broad availability of standard deviation metrics across virtually all publicly available mutual funds, few investment advisors go to the length of discussing this with clients, and fewer provide clients an indication of the standard deviation of their investment portfolio.
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