Tools To Calculate Risk In Mutual Fund: Standard Deviation

_{Published on: 17 Jun, 2024 12:00}

If you are looking for a way to measure the risk and volatility of a mutual fund, you may have come across the term standard deviation of return. But what does it mean and how can you use it to make better investment decisions? In this blog post, I will explain what the standard deviation of return is, how it is calculated, and why it is important for mutual fund investors.

Introduction

The standard deviation of return is a statistical measure that shows how much the returns of a mutual fund vary from its average over a given period of time. It is also known as historical volatility or annualized volatility. A higher standard deviation means that the fund's returns are more dispersed and unpredictable, while a lower standard deviation means that the fund's returns are more consistent and stable.

 

Numerical Example of Standard Deviation Calculation:

To calculate the standard deviation of return, you need to follow these steps:

1. Find the average return of the fund over a certain period, such as one year, three years, or five years. This is also called the mean return.
2. Subtract the mean return from each individual return in that period and square the result. This is called the squared deviation.
3.  Add up all the squared deviations and divide by the number of returns in that period. This is called the variance.
4.  Take the square root of the variance. This is the standard deviation of return.

• For example, let's say you have a mutual fund that has these annual returns over five years: 10%, 15%, 5%, -5%, and 20%.
• The mean return is 9% (10 + 15 + 5 - 5 + 20 / 5).
• The squared deviations are 1% (10 - 9)^2, 36% (15 - 9)^2, 16% (5 - 9)^2, 196% (-5 - 9)^2, and 121% (20 - 9)^2.
• The variance is 74% (1 + 36 + 16 + 196 + 121 / 5). The standard deviation of return is 8.6% (sqrt(74)).

 

 

Advantages of Standard Deviation in Mutual Funds:

1. Quantification of risk: Standard deviation helps quantify the risk associated with a mutual fund by measuring the dispersion of returns over time. It allows investors to objectively compare the risk profiles of different funds.
2. Diversification insights: By analyzing the standard deviation of different funds, investors can identify funds that have a low correlation to one another. This information can be used to construct a well-diversified portfolio that minimizes risk.
3. Performance benchmark: Standard deviation serves as a useful benchmark for gauging the performance of a fund manager. By comparing the standard deviation of a fund to that of its benchmark index, investors can assess whether the fund manager has effectively managed risk.

Disadvantages of Standard Deviation in Mutual Funds:

1. Limited to historical data: Standard deviation is based on historical returns, which may not be indicative of future performance. This limitation means that investors should use caution when relying on standard deviation as the sole measure of risk.
2. Insensitive to return distribution: Standard deviation does not differentiate between upside and downside volatility, making it an incomplete measure of risk. Investors should also consider other risk metrics like skewness and kurtosis to get a comprehensive understanding of a fund's risk profile.
3. Inadequate for non-normal distributions: Standard deviation assumes that returns follow a normal distribution, which may not always be the case. In situations where returns exhibit non-normal distributions, other risk measures like Value at Risk (VaR) might be more appropriate.

 

Here are some tips on how to use the standard deviation of return in your mutual fund analysis:

- Compare funds with similar objectives and strategies. For example, if you are looking for a large-cap growth fund, compare its standard deviation with other large-cap growth funds or with an index that represents that category.

- Look at different time periods. Standard deviation can change over time depending on market conditions and fund performance. A fund may have a low standard deviation in a calm market but a high standard deviation in a volatile market, or vice versa.

- Use standard deviation along with other risk measures. Standard deviation only captures how much a fund's returns deviate from its average, but it does not tell you anything about the direction or magnitude of those deviations. For example, a fund may have a low standard deviation but still lose money or underperform its benchmark. Other risk measures that you can use include beta, alpha, Sharpe ratio, Sortino ratio, and maximum drawdown.

The standard deviation of return is an important tool for mutual fund investors who want to understand how risky and volatile a fund is. By using it wisely and in conjunction with other risk measures and performance indicators, you can make more informed and confident investment decisions.

The standard deviation of return is an important tool for mutual fund investors who want to understand how risky and volatile a fund is. By using it wisely and in conjunction with other risk measures and performance indicators, you can make more informed and confident investment decisions.

Please note that investing in mutual funds involves risks. This blog post should not be construed as financial advice, and readers should consult with a qualified financial advisor before making any investment decisions.