Standard Deviation in Mutual Funds - Definition, Benefits & Formula

One of the most vital considerations while investing is the risk profile of the asset or security you’re interested in. For instance, if you are about to invest in a mutual fund, then it's necessary to check the risk profile of the scheme you’ve selected for your investment. You should only proceed if the risk level of the scheme matches your risk appetite. Standard deviation in mutual funds is commonly used for determining risk. Here are some of the most important things you should know about this statistical tool-

Standard deviation can be defined as a statistical measurement of the volatility of a mutual fund scheme. It demonstrates the degree of variation from the simple average or arithmetic mean.A higher standard deviation indicates greater volatility. In other words, if the standard deviation of a mutual fund is high, then the returns can be significantly higher or lower than the average. Thus, if the standard deviation of a scheme is 2% and its average annual return is 10%, then the future returns can range from 8%-12% (10%-2% and 10%+2%).

There are several reasons that make standard deviation important for mutual fund investors. Take a look-

• Overview of Total Risk- Unlike beta, which only indicates a scheme’s sensitivity towards market movements, the standard deviation is a broader metric that considers total risk.
• Indicates Potential Returns- With the help of this statistical tool, investors can better predict the returns they can generate from their mutual fund investment.
• Fund Selection- If you’re confused between two mutual funds belonging to the same category, then the standard deviation can be one of the factors that can help you make the selection.
• Match Risk Level- Investors can also use standard deviation to match their risk appetite with the risk profile of the mutual fund they’re interested in to make informed decisions.

Here’s the formula to calculate the standard deviation in mutual funds -Standard Deviation = √( (∑ (xi- x ̅ )2)/(n-1))Here-
Xiis the ithpoint in the data setX̅ is the mean value of the data setN is the total number of data points in the setWith the help of this formula, here’s how you can calculate the standard deviation-

1. Add all the data points and divide them by the total number of data points to calculate the mean value.
2. Subtract the mean from the data point value to calculate variance. Square each of the variance values and add them. Divide the results by the total number of data points minus one.
3. Use the square root value of the variance calculated in the 2ndpoint to calculate the standard deviation.

While standard deviation is an excellent tool to analyze the risk profile of mutual fund schemes, it cannot be used as a standalone tool for investing. Here are some of the reasons why-

• Only Measures Volatility Standard deviation only demonstrates the historical volatility of the mutual fund schemes. Other aspects, such as alpha (risk-adjusted performance), beta (fund volatility against market), etc., should also be analyzed before investing.
• Demonstrates Expected Volatility Range With standard deviation in mutual funds , you can only find out the expected volatility range of a scheme. It is very common for the actual volatility of the scheme to be significantly higher or lower than the expected range in any given year.
• Not Useful for Calculating Portfolio Volatility Standard deviation should only be used for analyzing the expected volatility of individual mutual funds. If you’ve created a portfolio with multiple schemes, then you can't calculate the combined average standard deviation of all the schemes to know the expected volatility of the entire portfolio.

Standard deviation is one of the most critical tools for analyzing mutual funds. By helping you know the expected volatility range of the schemes, it enables you to select funds that best match your risk appetite.
But while standard deviation is useful, investors should never select mutual funds solely based on this statistical tool. Several other data points such as alpha, beta, and more deserve equal attention.As it can take some time for you to master these variables, it’d be wise to consider the assistance of an experienced investment advisor, at least in the first few years of your investment journey.

The information contained herein is generic in nature and is meant for educational purposes only. Nothing here is to be construed as an investment or financial or taxation advice nor to be considered as an invitation or solicitation or advertisement for any financial product. Readers are advised to exercise discretion and should seek independent professional advice prior to making any investment decision in relation to any financial product. Aditya Birla Capital Group is not liable for any decision arising out of the use of this information.