When investing in mutual funds, most people focus on returns, but it’s equally important to consider risk. Understanding risk can help you make better investment decisions. One useful tool for measuring risk and volatility is standard deviation. It is a statistical measure that shows how much the returns of a fund vary from its average return.
Fund managers often use standard deviation to assess a fund’s stability. A higher standard deviation means more risk, while a lower one indicates stability. By understanding standard deviation, you can evaluate a fund’s risk level and make more informed and balanced investment choices.
What is Standard Deviation in Mutual Funds?
Standard deviation is an important metric used in mutual funds to measure risk and volatility. Standard deviation calculates min and maximum deviation from average to help understanding risk. Expressed as a percentage, it shows how much a fund’s returns are likely to deviate from its average annual returns.
By analyzing historical performance, standard deviation helps investors assess how stable or volatile a mutual fund’s returns have been over a specific period. A higher standard deviation indicates greater volatility, while a lower value suggests more stability.
To better understand a fund’s return risks, the formula STD + MEAN and STD – MEAN can be applied. This helps estimate the range within which the fund’s returns might fluctuate relative to its average annual returns. For example, if a mutual fund has a standard deviation of 3 and an average return of 10%, its return risks can be expected to fall between 7% (10% – 3%) and 13% (10% + 3%).
In simple terms the returns of the fund deviated from 7%-13% over a specific time period.
When selecting a mutual fund, consider your own risk appetite and investment horizon alongside the standard deviation. For example, if Fund A has a standard deviation of 14% and Fund B has a standard deviation of 12%, Fund A carries higher volatility. If you’re comfortable with higher risk for potentially higher returns, Fund A might suit you. However, for a conservative investor, Fund B would align better with a preference for stability.
How Does Standard Deviation Work?
Standard deviation is a statistical tool that measures how much a fund’s returns vary from its average return. It helps investors understand the volatility of a fund, indicating the potential range of fluctuations in returns. A lower standard deviation means the fund’s performance is more stable, while a higher value reflects greater unpredictability.
Formula:
Where:
- : Return for each period (e.g., monthly or yearly)
- Ravg: Average return across the same period
- N: Number of observations
This formula calculates the spread of returns around the average. By squaring the differences, it ensures all deviations, whether positive or negative, contribute equally.
Example:
If a mutual fund has an average return (R avg) of 12% and a standard deviation of 4%, the expected returns will usually range between 12%±4%12\% \pm 4\% (i.e., 8% to 16%) for 68% of the time.
Range of Returns Using Mean and Standard Deviation (Last 3 Years)
The following table summarizes the range of returns for the HDFC Small Cap Fund and its benchmark, the BSE 250 SmallCap TRI, using the formula:
Range=Mean Return± Standard Deviation
Fund/Index | Mean Return (%) | Standard Deviation (%) | Lower Range (%) | Upper Range (%) |
---|---|---|---|---|
HDFC Small Cap Fund | 24.10 | 14.66 | 24.10−14.66=9.44 | 24.10+14.66=38.76 |
BSE 250 SmallCap TRI | 23.49 | 17.81 | 23.49−17.81=5.68 | 23.49+17.81=41.30 |
Interpretation:
- HDFC Small Cap Fund: Over the past three years, this fund’s returns fluctuated between 9.44% and 38.76%. This reflects lower volatility compared to its benchmark.
- BSE 250 SmallCap TRI: The index’s returns ranged between 5.68% and 41.30%, indicating higher volatility than the fund.
This comparison highlights that the HDFC Small Cap Fund provides more consistent returns with lower risk compared to its benchmark.
Interpretation of Standard Deviation in Mutual Funds:
Standard deviation is calculated on 3 years of data, providing a robust and data-driven understanding of how a fund has performed over time. This approach enables investors to evaluate the consistency of a fund’s returns compared to its benchmark. Instead of simply focusing on average returns, which may look attractive but lack context, understanding the fund’s range of returns compared to the benchmark adds accuracy to decision-making.
This is because average returns do not reflect the ups and downs of market performance. By calculating standard deviation, which involves analyzing the monthly percentage changes in both the fund and its benchmark, investors can see a clearer picture of potential fluctuations. The live data used in this calculation ensures a practical and timely interpretation, making it a highly relevant tool for assessing mutual fund performance.
When investors look beyond average returns and focus on the variability captured through standard deviation, they gain better insight into the risk involved. For instance, instead of being overly optimistic about a fund with a high average return, understanding the range of returns compared to the benchmark can highlight whether those returns come with high volatility. This nuanced perspective can guide more accurate investment decisions, particularly for those aligning investments with their risk tolerance and financial goals.
The practicality of standard deviation lies in its real-time relevance, as it accounts for live market data rather than historical averages alone. Because the metric evaluates monthly percentage changes over a specific period, it effectively captures how funds and benchmarks respond to varying market conditions. This makes standard deviation in mutual funds an invaluable tool for investors aiming to balance risk and reward. It helps them avoid being swayed by high average returns and instead consider the broader performance range.
Limitations of Standard Deviation in Mutual Funds:
When it comes to evaluating mutual funds, standard deviation often takes center stage. While it’s a useful tool for assessing volatility, it has its limitations. If you’re relying on this metric alone, you might miss the bigger picture. Let’s dive into why.
1. Standard Deviation Cannot Estimate Returns:
One major drawback is that standard deviation cannot estimate the returns and returns ratio. It measures how much a fund’s returns fluctuate from the average, but it doesn’t provide insights into whether the fund delivers consistent or favorable returns. You’ll still need additional metrics to assess actual performance and growth potential.
2. Not Enough to Select Mutual Funds:
Standard deviation alone is not sufficient in selecting mutual funds. It only calculates deviation, which tells you the level of volatility but not whether that volatility is positive or negative. For instance, a high standard deviation might reflect large positive swings—or disastrous losses. Without proper context, it’s impossible to determine whether the deviation is beneficial.
3. There’s No Good or Bad Number:
When it comes to standard deviation, there is no specific good or bad number. It all depends on the fund’s benchmark. For example, a deviation that’s high for one category may be perfectly normal for another. To make sense of the number, you need to compare it to similar funds or the fund’s benchmark index.
4. Doesn’t Account for Other Risks:
Standard deviation focuses solely on price volatility. It doesn’t factor in other risks like credit risk, liquidity risk, or geopolitical uncertainty. Relying on it alone could leave you blind to critical factors that influence a fund’s performance.
What is Considered a Good Standard Deviation in Mutual Funds?
There isn’t a fixed number that defines a “good” standard deviation, as it depends on the context, particularly the fund’s benchmark and category.
Context of Benchmark:
A key factor in evaluating standard deviation is its relationship with the benchmark. There is no good or bad number; we must compare the standard deviation with the respective benchmark. For instance, if the benchmark for a specific category has a standard deviation of 40%, the fund’s standard deviation will typically be close to 40%. In such cases, a high standard deviation is not necessarily negative, as it reflects the natural volatility of the asset class or market segment. Similarly, when the benchmark’s standard deviation is lower, the fund’s standard deviation will also tend to be lower.
Risk Tolerance and Time Horizon:
Another important consideration is the investor’s risk appetite. For conservative investors, low-volatility funds with a standard deviation below 10% might be more appealing, especially for categories like debt funds. Moderate investors might prefer funds with standard deviations between 10% and 20%, balancing risk and potential returns. Aggressive investors seeking high growth may accept standard deviations above 20% in categories like small-cap equity funds.
Importance of Benchmark Comparison:
Whenever the standard deviation benchmark is low, it will also be less for the fund too. For example, a bond fund compared to a stable bond index will naturally have a lower standard deviation than an equity fund compared to a stock market index. This means the standard deviation number cannot be judged independently but must always be considered relative to the benchmark.
Tips for Investors:
- Know Your Risk Tolerance:
Understand how much risk you can handle. For example, if you don’t want big ups and downs, choose low-risk investments like debt funds. If you can take higher risks for better returns, equity funds may suit you. - Diversify Your Portfolio:
Don’t put all your money in one type of investment. For example, invest in a mix of equity funds, debt funds, and fixed deposits. This reduces overall risk and balances returns. - Focus on Long-Term Goals:
Mutual funds perform better over time. For example, if you’re saving for retirement in 20 years, equity funds can give good returns despite short-term market changes. - Compare Funds:
Look at metrics like standard deviation, returns, and Sharpe ratio. For example, if Fund A and Fund B both give 10% returns, but Fund A has lower risk (lower standard deviation), it might be a safer choice. - Check Expense Ratios:
High costs eat into returns. For example, if Fund A has a 1.5% expense ratio and Fund B has 0.8%, Fund B leaves you with more profit. - Review Regularly:
Keep track of your investments. For example, if your equity fund becomes too volatile or doesn’t match your goals, consider switching to a more stable option.
These simple steps can help you make better financial decisions and grow your wealth wisely.
Standard Deviation vs Other Risk Metrics:
1. Standard Deviation vs. Beta:
While standard deviation measures total risk, beta focuses on market-related risk by comparing a fund’s movements to a benchmark index. For example, a fund with a standard deviation of 10% might have a beta of 1.2, indicating it is 20% more volatile than the market. Beta is ideal for understanding a fund’s sensitivity to market changes, while standard deviation considers all risk factors.
2. Standard Deviation vs. Sharpe Ratio:
The Sharpe ratio evaluates risk-adjusted returns, showing how much return is generated for each unit of risk taken. For example, if Fund A has a standard deviation of 12% and a Sharpe ratio of 1.2, it offers better risk-adjusted returns than Fund B with the same standard deviation but a Sharpe ratio of 0.8.
3. Standard Deviation vs. Alpha:
Alpha measures a fund’s performance relative to its benchmark. A fund with a high standard deviation but positive alpha indicates that despite volatility, it outperforms the market.
Each metric has its strengths. Combining them offers a comprehensive view of a fund’s risk and performance.
Conclusion:
Standard deviation is a key tool in mutual fund investing, offering insights into risk and return variability. It helps investors compare funds, assess risk, and build diversified portfolios aligned with their goals. However, it is important to recognize its limitations and use it alongside other metrics, such as Sharpe ratio and Alpha, for a comprehensive evaluation. While standard deviation aids decision-making, additional research and professional advice are essential for a well-rounded investment strategy. Consulting a qualified financial advisor ensures that investments are tailored to individual goals and risk tolerance. Combining knowledge and guidance leads to smarter, more confident investing.