What is Standard Deviation in Mutual Funds, Meaning, Importance & Formula

When investing in a mutual fund, returns are frequently used as an evaluation metric. In addition to returns, a reasonable risk assessment will assist you in making prudent decisions. Using the statistical instrument standard deviation is one method for evaluating risks and volatility. The standard deviation, a ratio commonly used by fund managers, is of significant help to investors. Let's understand standard deviation and how it can help you assess risk more accurately.

What is Standard Deviation?

A standard deviation refers to a statistical tool for measuring the deviation of portfolio returns from their mean. The standard deviation helps to determine the investment risk. When investing in market-linked instruments, it is a crucial metric to consider. Due to the volatility of the markets, returns fluctuate daily. Both internal and external factors influence these fluctuations.

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A mutual fund's standard deviation indicates its volatility. Moreover, it indicates the deviation of a fund's returns from the projected returns based on its past performance.

Note that:

• A high standard deviation denotes greater return variation, while a lower value indicates less variation. 
• It is the variance of returns relative to the average over a given period. 
• A fund with a low standard deviation (three to five years) can indicate that it provides stable returns over the long term.

Moreover, you cannot determine whether a fund's standard deviation is high or low without comparing it to other investments in the same category. Low-risk investments, like debt mutual funds, have a standard deviation that is typically low. In contrast, equity-based funds will have a greater standard deviation than debt-based funds.

It is common practice to use the trailing monthly returns of 3, 5, and 10 years to determine the standard deviation. In addition, the monthly standard deviation values are converted to an annual basis and expressed as a percentage.

What is The Formula for Calculating Standard Deviation?

Here is the formula that can help you to calculate the standard deviation:
S= √( (∑ (xi- x ̅ )2 )/(n-1))

Here is a step-by-step process for calculating the standard deviation:

• Start by listing the annual returns for the mutual fund (X).
• Find the average return (X̅) of the investment returns.
• Then subtract the average return from each year's return, to get (X - X̅).
• Next, square the deviation (X - X̅) 2, for each year
• Please include all the values.
• Next, divide the sum by the total number of periods minus one (n-1).
• To find the standard deviation, calculate the square root of the value obtained.

What is The Importance Of Standard Deviation in Mutual Funds?

Standard deviation plays an essential role in mutual funds. Here is its importance:

1. Measures total risk: Standard deviation considers the overall risk, not just the volatility linked to the market. Thus, it is a more comprehensive measure than Beta.
2. Helps to compare similar funds: You can contrast funds from the same category: When choosing between two mutual funds in the identical category, the standard deviation may be a deciding factor.
3. Equally beneficial for Equity and Debt Schemes: Standard deviation is a useful metric for estimating the volatility of returns for equity and debt schemes. By applying standard deviation, you can compare the mutual fund's risk profile to your risk tolerance.
4. Future performance indicator: The standard deviation refers to the indicator of a mutual fund's future performance. In other words, you can calculate a fund's returns (moving up or down) via its mean/average returns and the standard deviation value.

Conclusion

Standard deviation represents one of the most important statistical tools for mutual funds. By analyzing each scheme's projected range of volatility, it enables you to choose funds that best meet your risk tolerance. Despite the usefulness of standard deviation, investors should never choose mutual funds entirely on the basis of statistical tools. Other data elements, like Alpha and Beta, require equal consideration.

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