Understanding standard deviation
Q. What is standard deviation? And is it something I should consider before investing in a fund?
A. How much risk and volatility you can handle as an investor — whether your investment choices allow you to sleep at night — is a very important part of your financial plan.
And that’s where standard deviation comes in.
Standard deviation is a measure of volatility of a mutual fund or any other investment, and it should absolutely be considered before investing, said Alison Williams, a certified financial planner with Stonegate Wealth Management in Oakland.
“A higher standard deviation implies more fluctuation from the average (a.k.a mean) return,” Williams said.
For example, if an investment has an average return of 10 percent and a standard deviation of 10 percent, then roughly seven out of 10 years the investment’s return will be 10 percent plus or minus the 10 percent standard deviation — or a range of 0 to 20 percent, Williams said.
“Two standard deviations — plus or minus 20 percent — is the range over which the investment’s annual return will occur 95 times out of 100,” she said. “Therefore there is a small chance that the fund’s return range from negative 10 percent to plus 30 percent in a year.”
Similar arithmetic would apply to three deviations, making the return, 99 percent of the time, between negative 25 percent and 35 percent, Williams said.
“The standard deviation of a fund should be in a range that is appropriate for your risk tolerance,” she said.