| One of the most popular ways that investors will | | | | The nice thing about knowing this statistical measure |
| determine the risks associated with a given | | | | is that it is specific to the security. In other words, |
| investment is to study its standard deviation. While | | | | although a security might be part of an overall index, |
| mildly complicated to arrive at, the standard deviation | | | | some may and will behave indifferently to whatever |
| provides a lot of valuable information about a | | | | the broader market is doing. And that level of |
| security's price and, specifically, how it will "typically" | | | | volatility might be independent of the market's |
| behave. | | | | volatility as well. Standard deviation tells us exactly |
| In its purest form, the standard deviation tells | | | | what to expect from such securities, regardless of |
| investors how much they can expect a security's | | | | what its relationship to the broader market might be. |
| price to fluctuate from its mean returns. That means | | | | The shortfall with this measure is that it is based on |
| that if a security normally earns 10% per year, a high | | | | historical data and can be fairly easily manipulated. |
| standard deviation will suggest that day-to-day | | | | Since it will measure returns over a period days, |
| fluctuations will be high while a a low standard | | | | weeks, months and sometimes years, the actual |
| deviation will indicate that fluctuations will be lower. In | | | | standard might be inaccurately masked behind |
| other words, securities a with standard deviation will | | | | longer-term market conditions (e.g. using the last 10 |
| be considered more volatile than securities with a low | | | | years) or can show inaccurately high deviation (e.g. |
| figure. | | | | using the last 6 months of volatile period). |
| The importance of knowing this numbers comes | | | | Therefore, caution should be exercised when relying |
| down to portfolio construction. Consider a | | | | on this measurement and depending on current |
| more-balanced investor who wants to enjoy steady | | | | market and economic conditions, the investor or |
| growth, understands there can be price fluctuations | | | | analyst will have to decide how "watered down" the |
| but really does not want to see large swings in a | | | | measurement should be (e.g. during periods of |
| portfolio's value. Putting together a family of | | | | heightened volatility, it may make better sense to |
| securities might involve choosing some stocks that | | | | adopt a longer-term period, such as a year or several |
| have higher volatility and offsetting those stocks with | | | | years). Regardless, investors should be well aware of |
| securities that have lower volatility. Std deviation | | | | the parameters that go into the standard deviation. |
| helps with this process. | | | | |