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 a particular set of historical data that could be measured either against itself (past prices of the same security) or as compared to some average or “benchmark.” This might be the market overall, a particular benchmark like the S&P 500, or the Dow Jones Industrial 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. 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 fall within one standard deviation95% of the time: returns fall within two standard deviations99.7% of the time: returns fall within three standard deviations
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. 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.
