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The market regulator SEBI, as in the Securities and Exchange Board of India, has mandated policies to protect small and mid-cap investors. The fund houses are now needed to disclose stress tests and risk parameters, like the standard deviation of the small/mid-cap portfolios.
But what exactly is the role of standard deviation (SD) in this context? Why is it essential for investors to understand standard deviation in mutual fund meaning to make educated choices about their investments? Let’s find the answers here!
Standard deviation: What is it?
The metric, in general, tells how dispersed data are from the mean. It quantifies how much the profit made by an investment can differ from the average return. If the value is high, the returns vary more. If it’s low, the returns are more consistent.
Also read: Beat the market: Your ultimate guide for fundamental analysis tools.
What is the standard deviation in mutual funds?
The indicator provides a clear idea of a fund’s volatility. When you see a high SD, it means the returns can deviate widely from the average. Therefore, there is more risk and more chances of ups and downs.
Say the portfolio’s average return is 15% with a deviation of 5%. Consequently, the gains will be like 10-20%. The value is good for risk-takers in the hope of boosted profit. But it might be too risky for those who prefer stability.
As opposed to that, in low-value, the returns are more consistent and close to the average. For instance, with a 2% standard deviation. The same 15% average as above. Returns would go around 13-17%. It is best for sceptics seeking steady gains.
The metric allows you to see the extent of risk you’re taking. Now you can make a choice that matches your sensitivity to risk. Higher SD suits risk-takers, while lower is for those who want more predictable returns.
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Standard deviation in mutual fund formula & calculation
Here’s the formula:
Source: Morningstar
Now, let’s check how to calculate standard deviation in mutual funds with hypothetical values.
Step 1: List the annual returns of the mutual fund. For example, let’s take the returns for five months.
| Month (2024) | Return (%) |
| June | 8 |
| July | 12 |
| August | 15 |
| September | 7 |
| October | 10 |
Step 2: Calculate the mean of these returns. Add them up and divide by the number of years.
Mean= (8+12+15+7+10)/5=10.4%
Step 3: Subtract the mean from each annual return to find the deviation for each year.
Like, 8−10.4=−2.4.
| Month (2024) | Return (X) (%) | Mean (X̅) (%) | (X – X̅) |
| June | 8 | 10.4 | -2.4 |
| July | 12 | 10.4 | 1.6 |
| August | 15 | 10.4 | 4.6 |
| September | 7 | 10.4 | -3.4 |
| October | 10 | 10.4 | -0.4 |
Step 4: Square each deviation to make all values positive.
| Month (2024) | Return (X) (%) | Mean (X̅) (%) | (X – X̅) | (X – X̅)2 |
| June | 8 | 10.4 | -2.4 | 5.76 |
| July | 12 | 10.4 | 1.6 | 2.56 |
| August | 15 | 10.4 | 4.6 | 21.16 |
| September | 7 | 10.4 | -3.4 | 11.56 |
| October | 10 | 10.4 | -0.4 | 0.16 |
Step 5: Add up all the squared deviations.
5.76+2.56+21.16+11.56+0.16=41.2
Step 6: Divide this sum by the number of years minus one (n-1). Here, n is 5.
Variance= (41.2)/(5-1)= 10.3
Step 7: Take the variance’s square root for the final value.
Standard deviation=√10.3≈3.21
3.21% is the standard deviation. If you’re wondering how to calculate the standard deviation of mutual funds in Excel? Follow the same steps.
If a folio’s returns follow a normal distribution, most of the profits will be close to the average return. Stats say, about 68% of the returns will fall within 1 standard deviation of the average. Plus, about 95% of the returns will fall within two standard deviations.
Catches in standard deviation in mutual fund
- Based on historical data: Standard deviation looks at past performance. It doesn’t guarantee future results. Market conditions can change, and past trends may not repeat.
- Only measures volatility: While it shows how spread out the returns are, it doesn’t consider other risks. It fails to check geopolitical, credit, or liquidity risk.
- Assumes normal distribution: Standard deviation assumes returns follow a normal pattern. But in real life, financial markets can have extreme events that this measure might not capture.
- Requires numeric data: It only works for investments with numeric return data. It’s not useful for assets like real estate or commodities, limiting its use.
- Needs comparison for context: The figure itself doesn’t mean much. You need to compare it with other funds in the same category to understand if it’s high or low.
Also read: Mutual funds or stocks: Which is a better investment?
Bottomline
Understanding this tool helps you see the risk and performance of a fund’s folio. It shows how much returns can vary. But it has limits and should be used with other tools.
FAQs
As far as SD in funds depends on how much risk you can take in. There’s no standard value or good standard deviation. Check the metric with other investments in the same category to understand the performance. According to your risk tolerance, you can decide if the number is acceptable for you and if it matches your investment goals.
A fund with a high SD means its returns diverge more from its mean. This indicates higher risk and more volatility in its performance. Such a fund can have big gains but also big losses. It’s suitable for investors who can handle more risk and are looking for higher potential returns.
A normal standard deviation for a portfolio varies based on the type of investments. For a balanced portfolio, it might be moderate. For a portfolio with mostly stocks, it could be higher. For one with more bonds, it could be lower. There’s no exact number, so it’s important to compare it with similar portfolios to see if it’s normal. This helps you understand the risk level.
To calculate, first, list the fund’s returns. Next, find the average return. Subtract this average from each return to get deviations. Then, square each deviation. Add up all these squared deviations. Divide this total by the number of years minus one. Finally, take the square root of this result. This gives you the standard deviation, showing how much the returns vary from the average.
We calculate standard deviation to see how much the returns of an investment vary from the average. It helps us understand the risk. If the standard deviation is high, the returns are more spread out and risky. If it’s low, the returns are more stable and predictable. This way, investors can know if they’re taking a lot of risk or playing it safe.
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