Course 203: Looking at Historical Risk, Part 1
Standard Deviation
 In this course 1 Introduction 2 Standard Deviation 3 Beta

Standard deviation is probably used more often than any other measure to gauge a fund's risk. Standard deviation simply quantifies how much a series of numbers, such as fund returns, varies around its mean, or average. Investors like using standard deviation because it provides a precise measure of how varied a fund's returns have been over a particular time frame both on the upside and the downside. With this information, you can judge the range of returns your fund is likely to generate in the future. Morningstar calculates standard deviations for the most recent 36 months of a fund's life. The more a fund's returns fluctuate from month to month, the greater its standard deviation.

For instance, 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 didn't change from one month to the next. But here's where it gets tricky: A mutual fund that lost 1% each and every month would also have a standard deviation of zero. Why? Because, again, its returns didn't vary. Meanwhile, a fund that gained 5% one month, 25% the next, and that lost 7% the next would have a much higher standard deviation; its returns have been more varied.

Standard deviation allows a fund's performance swings to be captured into a single number. For most funds, future monthly returns will fall within one standard deviation of its average return 68% of the time and within two standard deviations 95% of the time.

Let's translate. Say a fund has a standard deviation of four and an average return of 10% per year. Most of the time (or, more precisely, 68% of the time), we can expect the fund's future returns to range between 6% and 14% or its 10% average plus or minus its standard deviation of four. Almost all of the time (95% of the time), its returns will fall between 2% and 18%, or within two standard deviations of its mean.

Using standard deviation as a measure of risk can have its drawbacks. It's possible to own a fund with a low standard deviation and still lose money. In reality, that's rare. Funds with modest standard deviations tend to lose less money over short time frames than those with high standard deviations. For example, the one-year average standard deviation among ultrashort-term bond funds, which are among the lowest-risk funds around (other than money market funds), is a mere 0.64%.

The bigger flaw with standard deviation is that it isn't intuitive. Sure, a standard deviation of seven is obviously higher than a standard deviation of five, but are those high or low figures? Because a fund's standard deviation is not a relative measure which means it's not compared with other funds or with a benchmark it is not very useful to you without some context.

So it's up to you to find an appropriate context for standard deviation. To help determine if your fund's standard deviation is high or low, we suggest you start by looking at the standard deviations of similar funds, those in the same category as the fund you're examining. In May 2011, for example, the average mid-cap growth fund carried a standard deviation of 26.4, while the typical large-value fund's standard deviation was 22.5. You can also compare a fund's standard deviation with that of a relevant index. The S&P 500, a common benchmark for large-cap funds, for example, had a standard deviation of 21.7 in May 2011.

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