Standard Deviation
By
MARSHALL HARGRAVE
Reviewed by
SOMER ANDERSON
on April 15, 2021
TABLE OF CONTENTS
What Is Standard Deviation?
Understanding the Standard Deviation
Example of Standard Deviation
What Is Standard Deviation?
A standard deviation is a statistic that measures the dispersion of a dataset
relative to its mean. The standard deviation is calculated as the square root of
variance by determining each data point's deviation relative to the mean. If the
data points are further from the mean, there is a higher deviation within the data
set; thus, the more spread out the data, the higher the standard deviation.
KEY TAKEAWAYS:
Standard deviation measures the dispersion of a dataset relative to its
mean.
A volatile stock has a high standard deviation, while the deviation of a
stable blue-chip stock is usually rather low.
As a downside, the standard deviation calculates all uncertainty as risk,
even when it’s in the investor's favor—such as above-average returns.
Standard Deviation
Understanding the Standard Deviation
Standard deviation is a statistical measurement in finance that, when applied to
the annual rate of return of an investment, sheds light on that
investment's historical volatility. The greater the standard deviation of securities,
the greater the variance between each price and the mean, which shows a larger
price range. For example, a volatile stock has a high standard deviation, while
the deviation of a stable blue-chip stock is usually rather low.
The Formula for Standard Deviation
\begin{aligned} &\text{Standard Deviation} = \sqrt{
\frac{\sum_{i=1}^{n}\left(x_i - \overline{x}\right)^2} {n-1} }\\
&\textbf{where:}\\ &x_i = \text{Value of the } i^{th} \text{ point in the
data set}\\ &\overline{x}= \text{The mean value of the data set}\\ &n =
\text{The number of data points in the data set} \end{aligned}
Standard Deviation=n−1∑i=1n(xi−x)2where:xi=Value of the ith point in the
data setx=The mean value of the data setn=The number of data points in th
e data set
Calculating the Standard Deviation
Standard deviation is calculated as follows:
1. The mean value is calculated by adding all the data points and dividing by
the number of data points.
2. The variance for each data point is calculated by subtracting the mean
from the value of the data point. Each of those resulting values is then
squared and the results summed. The result is then divided by the number
of data points less one.
3. The square root of the variance—result from no. 2—is then used to find the
standard deviation.
Using the Standard Deviation
Standard deviation is an especially useful tool in investing and trading strategies
as it helps measure market and security volatility—and predict performance
trends. As it relates to investing, for example, an index fund is likely to have a low
standard deviation versus its benchmark index, as the fund's goal is to replicate
the index.
On the other hand, one can expect aggressive growth funds to have a high
standard deviation from relative stock indices, as their portfolio managers make
aggressive bets to generate higher-than-average returns.
A lower standard deviation isn't necessarily preferable. It all depends on the
investments and the investor's willingness to assume risk. When dealing with the
amount of deviation in their portfolios, investors should consider their tolerance
for volatility and their overall investment objectives. More aggressive investors
may be comfortable with an investment strategy that opts for vehicles with
higher-than-average volatility, while more conservative investors may not.
Standard deviation is one of the key fundamental risk measures that analysts,
portfolio managers, advisors use. Investment firms report the standard deviation
of their mutual funds and other products. A large dispersion shows how much the
return on the fund is deviating from the expected normal returns. Because it is
easy to understand, this statistic is regularly reported to the end clients and
investors.
Standard Deviation vs. Variance
Variance is derived by taking the mean of the data points, subtracting the mean
from each data point individually, squaring each of these results, and then taking
another mean of these squares. Standard deviation is the square root of the
variance.
The variance helps determine the data's spread size when compared to
the mean value. As the variance gets bigger, more variation in data values
occurs, and there may be a larger gap between one data value and another. If
the data values are all close together, the variance will be smaller. However, this
is more difficult to grasp than the standard deviation because variances
represent a squared result that may not be meaningfully expressed on the same
graph as the original dataset.
Standard deviations are usually easier to picture and apply. The standard
deviation is expressed in the same unit of measurement as the data, which isn't
necessarily the case with the variance. Using the standard deviation, statisticians
may determine if the data has a normal curve or other mathematical relationship.
If the data behaves in a normal curve, then 68% of the data points will fall within
one standard deviation of the average, or mean, data point. Larger variances
cause more data points to fall outside the standard deviation. Smaller variances
result in more data that is close to average.
A Big Drawback
The biggest drawback of using standard deviation is that it can be impacted by
outliers and extreme values. Standard deviation assumes a normal
distribution and calculates all uncertainty as risk, even when it’s in the investor's
favor—such as above-average returns.
Example of Standard Deviation
Say we have the data points 5, 7, 3, and 7, which total 22. You would then divide
22 by the number of data points, in this case, four—resulting in a mean of 5.5.
This leads to the following determinations: x̄ = 5.5 and N = 4.
The variance is determined by subtracting the mean's value from each data
point, resulting in -0.5, 1.5, -2.5, and 1.5. Each of those values is then squared,
resulting in 0.25, 2.25, 6.25, and 2.25. The square values are then added
together, giving a total of 11, which is then divided by the value of N minus 1,
which is 3, resulting in a variance of approximately 3.67.
The square root of the variance is then calculated, which results in a standard
deviation measure of approximately 1.915.
Or consider shares of Apple (AAPL) for the last five years. Returns for Apple’s
stock were 12.49% for 2016, 48.45% for 2017, -5.39% for 2018, 88.98% for 2019
and, as of Sep., 60.91% for 2020. The average return over the five years using
a geometric mean calculated was 36.88%.1
The absolute value of each year's return minus the mean is thus 24.39%,
11.57%, 42.27%, 52.1%, and 24.03%, respectively. All those values are then
squared to yield 0.059, 0.013, 0.179, 0.271, and 0.058. The sample variance is
the average of the squared difference, or 0.145, where the squared values are
added together and divided by 4 (N minus 1). The square root of the variance is
taken to obtain the standard deviation of 38.08%.
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