Standard Deviation
A statistical measure of the dispersion of returns around the mean. In investing, it quantifies volatility—higher standard deviation means more unpredictable returns.
Standard deviation is the most common measure of investment risk. It tells you how much an investment's returns typically deviate from its average return. For example, if a fund has an average annual return of 10% with a standard deviation of 15%, roughly two-thirds of the time its annual return will fall between −5% and +25%.
Practical Implications
Standard deviation is used in many portfolio metrics:
- The Sharpe ratio divides excess return by standard deviation
- Modern Portfolio Theory uses it to optimize the risk-return tradeoff
- It forms the basis of confidence intervals in Monte Carlo simulations
One important limitation is that standard deviation treats upside and downside deviations equally. An investment that occasionally delivers outsized gains will have a high standard deviation even though investors generally welcome those surprises. For this reason, some analysts prefer downside-only measures like semi-deviation or max drawdown.