WHAT IS STANDARD DEVIATION?

In finance and investment, understanding and managing risk is of paramount importance. Among the tools available to financial professionals, one stands out as a cornerstone in risk assessment: Standard Deviation. Standard deviation, a fundamental statistical concept, offers insights into the variability and dispersion of data around an average, providing crucial information for decision-making in investment strategies.

This blog aims to explore the significance of standard deviation in finance, understanding its role in measuring risk, evaluating investment outcomes, and informing portfolio management decisions. Through a comprehensive examination of standard deviation’s principles, applications, and advantages, readers will gain a deeper understanding of its importance.

Join us as we discover more about the said statistical function!

Standard Deviation Definition

Standard deviation is a statistical term used to measure the amount of variability or dispersion around an average. Technically, it is a measure of volatility. Dispersion refers to the difference between the actual value and the average value. The larger this dispersion or variability, the higher the standard deviation.

Case to Consider

Imagine you invest in XYZ shares, which generate an average year-on-year return of 25%. In comparison, other stocks generate no more than 20%. At first glance, XYZ shares might seem like the better investment due to the higher returns.

However, in today’s quantitative-heavy investing environment, understanding risk is crucial. Managers are cautious about investing in shares with high volatility, which is where standard deviation comes in. A higher standard deviation indicates greater volatility, meaning the stock’s price can fluctuate significantly. While XYZ shares offer higher returns, their risk, or standard deviation, might also be higher, leading to potential instability.

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Business Consideration

An average return, or any average, never tells the full story. While it provides the central value of the data, it does not indicate the spread. For instance, an average return of 25% suggests you can generate this return, but it does not reveal that the actual returns could range from -10% to 60%. The average may be 25%, but you might have to exit at -10%.

Therefore, it’s crucial to measure the spread, which is akin to risk. Standard deviation helps us understand this spread, offering a more comprehensive view of potential investment outcomes.

Measuring Spread (Risk) using Range

We love asking this question in all the workshops we conduct! If we were to ask you for the simplest measure of spread, what would pop into your mind? Don’t tell us it’s standard deviation or variance (95% of the time, we get this answer)!

We would say the simplest measure is the range [Min, Max]. It gives us a fair idea of the spread. However, it only tells part of the story. The minimum and maximum values might be skewed. The range would be the same for data sets that are uniform but have extreme min and max values, as well as for skewed data around min and max.

Excel provides simple functions to calculate range using MIN and MAX.

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Measuring Spread Using Standard Deviation

Just as the range gives us a simple measure of spread by indicating the minimum and maximum values of the data, we have another measure called standard deviation (or an equivalent measure called variance) to measure spread more comprehensively.

Standard deviation essentially:

• Measures the spread (differences of individual data points) from the mean.
• Squares these differences (so that all values become positive).
• Averages these squared differences.
• Takes the square root of this average (for standard deviation).

Excel makes this process easier. Simply use the functions STDEVP or VARP and input your data. These functions handle all the calculations for you.

• Use STDEVP for measuring standard deviation.
• Use VARP for measuring variance.

Reasons Why Standard Deviation is Very Popular

Standard deviation has several advantages over other measures of spread:

• Deviation from the Mean: It measures the deviation from the mean, which is an important statistic indicating the central tendency of the data.
• Positive Values: By squaring the differences, it converts all values to positive, ensuring that deviations do not cancel each other out.
• Weighting Deviations: Squaring small deviations makes them even smaller (contraction effect), while large deviations become larger (expanding effect). This highlights significant variations and minimizes the impact of minor ones.
• Mathematical Properties: The square function has desirable mathematical properties that facilitate further statistical analysis.

Standard Deviation and Finance

Standard deviation is arguably one of the most crucial concepts in finance. In the domain of finance and banking, where risk measurement and management are paramount, standard deviation serves as a key tool. Portfolio managers rely heavily on standard deviation to gauge and monitor risk.

One of the cornerstones of portfolio management, the Sharpe Ratio, which earned William Sharpe a Nobel Prize, utilizes standard deviation to assess risk-adjusted returns. This ratio incentivizes portfolio managers to generate returns while minimizing risk.

Have you encountered any problems related to standard deviation in your experiences? If so, we’d love to hear about them!

In the finance industry, certification like the Financial Risk Manager® (FRM®) place significant emphasis on risk measurement and management. Numerous exam questions are based on concepts related to measuring standard deviation and other related metrics.

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At EduPristine, we provide the frm course with all the necessary arrangements a student could ask for. We are the Approved Exam Prep Providers of the Global Association of Risk Professionals, the body that offers the course. More than being the Exam Prep Providers, we believe that our values of student success and their employability have taken us this far. Fifteen years in the industry is no joke. To stand by these principles, we have taken multiple steps to remain aligned with our goals.

We have equalized the price of our two different modes of instruction, i.e., the classroom and the Live Virtual Classroom mode, so that you don’t have to worry about price differentiation while considering switching between modes. We have kept the validity to attend any batch for one full year at one price, which means if the course costs you “x” amount, then in that “x” amount you can attend “n” number of batches, whether live or classroom, for one whole year.

Additionally, we provide students with recordings of their live lectures in their Learning Management System portal for repeated revision. There are mock tests, crash courses, and doubt-solving sessions for students’ aid. Apart from all this, we also provide 7-days-a-week customer care support for all your administrative needs. We have also collected testimonials from students who have learned through us. We always encourage our new students to go through the testimonials page once before making any decision. It helps guide them and check our credibility. Furthermore, we have a dedicated team of career counselors who are readily available to conduct a quick session, either physically or virtually, to provide you with information on frm course details or to resolve any doubts you may have. Please feel free to contact us; we will be more than happy to assist you, not just once, but always! Happy learning!