What is Standard Deviation in Mutual Funds?

For investors, knowing how to measure and control risk is the key to attaining financial objectives. One tool investors can use is the standard deviation, showing how far apart mutual fund returns are from their average. That helps them understand the investment's volatility and risk. Let's discuss the standard deviation in mutual funds in detail.

Understanding Standard Deviation

A standard deviation is a statistical measure that shows the range or spread of a set of values. It is commonly used in finance to determine the deviation of individual data points from the mean of a dataset. 

Standard deviation is relevant for measuring risk in mutual funds because it provides a deviation of how returns move. The standard deviation provides investment insight into the fund's historical performance and the uncertainty of future returns.

A higher standard deviation indicates that the returns could differ substantially from the average value, making it an even higher risk. Conversely, a low standard deviation results in much steadier returns, making the fund safer.

Importance of Standard Deviation in Mutual Funds

Investors use standard deviation in mutual funds for the following purposes:

• Risk Assessment

A higher standard deviation means the chances of large fluctuations in a fund's returns are higher, and it can lead to sharp price swings for an investment. Volatility does not necessarily mean large profits; it can lead to extreme losses too. Investors need to understand this fact. The standard deviation in mutual fund performance allows investors to analyse the possible fluctuations and be better prepared to face shifting market conditions.

• Comparing Mutual Funds

The risk levels of varied funds can be easily compared with this metric, which helps the investor make a more informed investment decision. For instance, more risk-averse investors may like a portfolio with a more minor standard deviation for stability. In contrast, investors who can afford higher risk for potential returns may prefer funds that have a larger standard deviation. 

• Diversification of Portfolios

Based on the standard deviation of several assets, investors can combine different mutual funds to gain the best balance of risk and return. For instance, combining funds with a higher standard deviation with those with a lower standard deviation smoothes returns and offers more low-volatility investments, which typically enhances a steadier investment experience.

Standard Deviation Calculation

The standard deviation (SD) formula quantifies the dispersion of data points around the mean (average). For a set of values, it is calculated using the following formula:

SD= √(X - µ)2 / (N - 1)

Where:

• Xi​ = Each return
• μ = Mean of the returns
• N = Total number of returns

This formula captures how much the returns deviate from the average, providing insight into the investment's volatility.

Consider a hypothetical mutual fund with the following monthly returns over a year: 2%, 3%, -1%, 4%, 5%, 0%, 3%, 2%, 4%, -2%, 1%, 3%.

1. Monthly returns: Xi =  [2, 3, -1, 4, 5, 0, 3, 2, 4, -2, 1, 3]
2. μ= 1.83% 
3. Deviations: Xi – μ = [0.17, 1.17, -2.83, 2.17, 3.17, -1.83, 1.17, 0.17, 2.17, -3.83, -0.83, 1.17]
4. Squared Deviations =  [0.0289, 1.3689, 8.4489, 4.7089, 10.0889, 3.3489, 1.3689, 0.0289, 4.7089, 14.6689, 0.6889, 1.3689]
5. Sum = 50.035
6. SD = 50.03511 ≈2.13

In this example, the standard deviation of approximately 2.13 indicates the risk associated with the mutual fund's returns, helping investors understand the fund's volatility.

How Can Investors Use Standard Deviation to Choose Mutual Funds?

Generally, higher returns relate to higher volatility. Funds that promise higher returns are often reported to exhibit higher standard deviations. However, such a relationship does not always have to be linear; some funds may have high returns with moderate risks, and others might present big risks without promising high returns. 

Standard deviation can greatly help in comparing equity funds with debt funds. The standard deviation of return will be higher in equity funds due to the stock market volatility. Debt funds usually have lower standard deviations; they depict a relatively stable return and reduce risk. This also makes it easier for investors to select an investment strategy that comes well with their risk capacity and market conditions.

For instance, an equity fund with a standard deviation of 15% would depict a significant risk and reward. The conservative bond fund may have a standard deviation of only 4%, showing stability with reduced returns. With such differences, investors can take an informed call on the types of investments they make per their given financial goals and risk profile.

Standard deviation measures the risk but also limits investors from some assumptions. It assumes the normality of returns. Hence, it may underestimate extreme event risks and does not differentiate upside from downside volatility. Reliance on standard deviation alone as a measure of risk is not advisable. Therefore, using this metric with other risk measures is essential for a more comprehensive analysis of mutual funds.

Conclusion

Standard deviation is an essential measure for mutual fund investors. It gives insights into volatility and the risk level of a fund's return. Understanding the standard deviation helps investors make better, more rational choices as it ensures their portfolios are in sync with the risks for their investment plans. While it is a useful tool for assessing risk and comparing funds, it is essential to consider its limitations and use it with other measures for a comprehensive investment strategy.