What is standard deviation in mutual funds and why is it important?

When investing in mutual funds, understanding the risks involved is crucial. This knowledge can help you choose a scheme that suits your risk tolerance levels – the amount of fluctuation in your investment’s value you are willing to tolerate in exchange for return potential. Aligning your investment avenue with your risk appetite can result in a smoother investment experience.

A commonly used and simple measure of risk is standard deviation. Let’s take a closer look at what mutual fund standard deviation is, how it is calculated, and how it can help in portfolio management.

• Table of contents

1. Understanding standard deviation in mutual funds
2. Formula and Calculation of Standard Deviation
3. How does Standard Deviation work?
4. Role of standard deviation in portfolio management
5. How standard deviation helps in portfolio management

Understanding Standard Deviation in Mutual Funds

Standard deviation is a statistical measure that shows how much a mutual fund's returns deviate from its average return over a certain period. It is a useful indicator of the fund's volatility and, by extension, the risk associated with it. A higher standard deviation signifies higher volatility, indicating that the fund's returns fluctuate more widely from the average.

Formula and Calculation of Standard Deviation

To Calculate the Standard Deviation, Follow These Steps:

1. Find the average return: Determine the return percentage of a scheme over a certain period (say, five years). Add the return figures and divide this by the period.
2. Calculate the differences: Subtract the average return from each period's return.
3. Square the differences: Square each difference to remove negative values.
4. Find the average of squared differences: Sum up the squared differences and divide by the number of periods.
5. Take the square root: The square root of the average of squared differences gives the standard deviation.

Calculation: Consider a mutual fund with the following annual returns over five years: 8%, 12%, 10%, 6%, and 14%.

• Average Return: (8 + 12 + 10 + 6 + 14) / 5 = 10%
• Differences from Average: (8-10)², (12-10)², (10-10)², (6-10)², (14-10)² = 4, 4, 0, 16, 16
• Average of Squared Differences: (4 + 4 + 0 + 16 + 16) / 5 = 8
• Standard Deviation: √8 ≈ 2.83%

How does Standard Deviation work?

When a mutual fund exhibits a high standard deviation, it indicates that its returns have historically fluctuated significantly from the average returns. This means that while there is potential for higher returns, there is also a higher risk of losses. Conversely, a low standard deviation signifies less fluctuation, making such funds potentially less risky but also possibly offering lower returns. Therefore, understanding standard deviation enables investors to align their investment choices with their risk tolerance.

In practical terms, standard deviation helps investors compare multiple funds. For instance, if two funds offer similar average returns, the one with the lower standard deviation may potentially have fluctuations in its returns. The comparison allows investors to make more informed decisions about where to allocate their money based on their financial goals and risk appetite.

Moreover, standard deviation can also aid portfolio diversification. Analysing the standard deviations of various funds can help investors combine asset classes with different levels of volatility to create a more balanced portfolio. The diversification can help mitigate overall risk.

However, standard deviation only measures past performance volatility and does not predict future risks or returns. It may be used alongside other metrics like beta or Sharpe ratio for a more comprehensive evaluation of a fund.

Role of Standard Deviation in Portfolio Management

In portfolio management, standard deviation helps investors assess the risk associated with different mutual funds. By comparing the standard deviations of various funds, investors can determine which funds have higher or lower volatility. This information is useful for constructing a diversified portfolio that matches an investor’s risk tolerance.

How Standard Deviation Helps in Portfolio Management

• Risk assessment: Standard deviation helps investors identify the risk level of different mutual funds. Funds with higher standard deviations may be riskier and more volatile, while those with lower standard deviations are more stable.
• Performance comparison: Investors can compare the performance of funds with similar returns by looking at their standard deviations. A fund with a lower standard deviation is preferable if it offers the same return as a fund with a higher standard deviation, as it indicates less risk.
• Investment strategy: Standard deviation helps investors align their investment strategies with their risk tolerance. Conservative investors might prefer funds with lower standard deviations, while aggressive investors might opt for funds with higher standard deviations.
• Diversification: By combining funds with different standard deviations, investors can diversify their portfolios. This can reduce overall risk and improve the chances of achieving more stable returns.

Conclusion

Standard deviation is a crucial measure for understanding the risk and volatility of mutual funds. It helps investors make informed decisions, manage risk, and build diversified portfolios. By considering the standard deviation, investors can better align their investments with their risk tolerance and financial goals. Furthermore, using a mutual fund compounding calculator can offer valuable insights into how compounding can significantly influence your investment growth, thus helping with effective financial planning. Understanding a fund's return potential as well as its risk metrics can help develop a well-rounded approach.

FAQs

What is the significance of standard deviation in mutual fund investing?

Standard deviation measures the volatility of a mutual fund's returns, helping investors understand how much the investment value is likely to fluctuate.

How does standard deviation differ from other measures of risk in mutual funds?

Standard deviation specifically measures the variability of returns. Other measures include beta, which assesses a fund’s sensitivity to market movements, and alpha, which measures the performance relative to a benchmark. Meanwhile, Sharpe ratio measures a fund’s risk-adjusted returns (how much return an investment generates in relation to the risk taken)

Can a high standard deviation indicate better returns?

Not necessarily. A high standard deviation indicates higher volatility, which means the returns can vary widely. It suggests higher risk but does not guarantee better returns.

How should investors interpret standard deviation when selecting mutual funds?

A higher standard deviation indicates higher volatility. Investors should use standard deviation to gauge the risk level of mutual funds and choose those that match their risk tolerance and investment goals.

Does standard deviation alone provide a complete picture of a mutual fund's risk?

No, standard deviation should be used along with other measures like beta, alpha, and Sharpe ratio to get a comprehensive view of a mutual fund's risk and performance.

What is a good standard deviation?

A standard deviation measure is not inherently good or bad. A suitable standard deviation depends on the context and the dataset being analysed. In investments, for example, a low standard deviation may indicate less volatility and more consistent return potential, which might be desirable for risk-averse investors. However, it is neither inherently good nor bad; it must be assessed relative to the mean and compared with peers or benchmarks to determine suitability for your goals

Why is standard deviation important?

Standard deviation is important because it helps assess the volatility of investments, enabling better risk evaluation. For example, a high standard deviation indicates greater variability in returns, implying higher risk, while a low standard deviation suggests consistency. This insight allows investors to align their choices with their risk appetite and financial goals.

Mutual Fund investments are subject to market risks, read all scheme related documents carefully. This document should not be treated as endorsement of the views/opinions or as investment advice. This document should not be construed as a research report or a recommendation to buy or sell any security. This document is for information purpose only and should not be construed as a promise on minimum returns or safeguard of capital. This document alone is not sufficient and should not be used for the development or implementation of an investment strategy. The recipient should note and understand that the information provided above may not contain all the material aspects relevant for making an investment decision. Investors are advised to consult their own investment advisor before making any investment decision in light of their risk appetite, investment goals and horizon. This information is subject to change without any prior notice.