How standard deviation explains risk?

Key Takeaways

  • There are many risks in investing, standard deviation looks at how intense the historical price swings of an asset are in the market.
  • There are ways to reduce overall portfolio volatility by adding low-volatility assets like bonds to the portfolio.
  • Volatility is not necessarily bad as it allows for buying opportunities to exist when prices drop.
  • The best way to handle volatility is to understand the true value of the asset and ignore short-term price swings.
  • When we say “risk”, we really mean our investments going down in value or, in worst cases, to zero. However, it is not typical for businesses to just collapse and go bankrupt or for governments to default on their loans.

    Thus, risk really means the probability of an investment going south by a certain percentage.

    Investors and analysts use multiple metrics to measure the volatility and risk of various investment vehicles. One of the common metrics typically quoted is standard deviation.

    What is the standard deviation?

    Standard deviation comes from mathematics and measures volatility from the mean of a value. When we talk about investing and standard deviation, we talk about how the price of an asset fluctuates from its average price. https://en.wikipedia.org/wiki/Standard_deviation

    If prices fluctuate significantly, the standard deviation is high and vice-versa. So, volatile prices mean a high standard deviation, and stable prices mean a low standard deviation. As mentioned before, it is not the only metric, but it is the easiest to understand.

    How does standard deviation translate to investing?

    We know that standard deviation represents the volatility of a stock, bond, or whole portfolio values. Portfolios with values that range significantly day to day or month to month have a greater risk. That is because we assume that portfolios will continue to behave in the same way in the future. So when we want a stable growth portfolio, we don’t want a portfolio that swings 20% in value every month.

    We have the ability to choose investments with higher or lower volatility. Here is an example of Tesla stock. Below is Tesla’s price graph with one month volatility graph.

    Tesla price history and volatility

    Purple line is historical price and blue line is 1M stock price volatility measured by standard deviation times the square root of number of periods in the time horizon.

    Compare that to a “boring” company like The Procter & Gamble. If your goal was to avoid serious price swings, PG would be a better addition to your portfolio.

    PG vs TESLA price history and volatility

    If I don’t sell my investments, why do I care how much they fluctuate?

    We keep repeating on this site that short-term fluctuations in prices don’t matter. Stocks, as an example, go up or down in value every second. We shouldn’t worry about that and only think of the long-term change to the price of underlying assets, in this case, actual businesses behind the stocks. But life is not always that simple and predictable. There will be times when you will want to liquidate part of your portfolio or your whole portfolio and do it quickly. If you own a portfolio with a high standard deviation and the timing is wrong, you see it drop 30%, but you don’t have a choice and have to sell; you will realize a 30% loss. Now you can see that buying a portfolio with a lower standard deviation typically will mean less risk in these scenarios. It is vital for people with shorter investment horizons due to upcoming retirement or needing access to invested capital sooner.

    Volatility is not all bad.

    Chasing a portfolio with the lowest possible volatility would be unwise. Volatility goes both ways. Prices go up as well as down, and we do want prices to go up. That is why typically, a well-constructed portfolio has both higher and lower volatility assets. Higher volatility assets generate growth potential, while low volatility assets provide stability. 

    How do I create a low volatility portfolio?

    Having low volatility is usually not the ultimate goal. Capital gains or stable income are more prominent goals of a portfolio. However, volatility should not be ignored. Most popular lazy portfolios, reduce overall volatility by mixing high-volatility assets, like stocks, with relatively low-volatility assets like bonds.

    If you are interested in creating a portfolio of your own and unsure where to start, we recommend either our Free Investment Guide or any of the free portfolios that we discuss on this site. Under the performance section, we report the Stdev and breakdown of portfolio assets and how much each asset contributes to the overall portfolio risk.

    Andy

    Andy is the author behind most posts AlternaInvest.com, a web site analyzing and simplifying alternative and traditional investment vehicles.

    Recent Posts