Standard deviation of fund returns measures how much a fund´s total returns have fluctuated in the past. The term
volatility is often used to mean standard deviation. This number is useful for two reasons. Firstly, because the more a fund´s return fluctuates, the riskier the fund is likely to be; standard deviation facilitates comparisons across all funds, from cash to emerging market equities. Secondly because funds that have been more volatile in the past tend to be the more volatile in the future. In that sense, standard deviation is a useful warning sign. The standard deviation is expressed in percentage terms, just like the returns. We calculate it based on the fund´s most recent 36 monthly returns. How to use it? The simplest use is to compare funds. Additionally, you can estimate the range of returns that a fund can experience in any given year. This gives a useful estimate of how low returns can go. To perform this simple estimate, you just need two numbers we provide: average return and standard deviation. You can estimate that, 95% of the time, the lowest annual return will be equal to the average return minus twice the standard deviation. Conversely, the maximum typical return, 95% of the time, will be equal to the average return plus twice the standard deviation. Example 1. A money market fund had an annual average return of 6%, with a standard deviation of 1%. The typical maximum annual return you would expect is: 6+1+1= 8%; the typical lowest return you would expect is 6-1-1=4%. In other words, if the fund continues to behave as it has in the past, 95% of the time, its annual returns will be between 4% and 8%. Example 2. An equity fund has experienced an average return of 18%, with standard deviation of 30%. Applying the same calculation, you can see that this fund´s typical annual returns will be between a negative 42% and a positive 78%. So even in good times, you can obtain an estimate of the downside for a given fund. Need a more technical explanation? We are able to estimate extreme returns in such a way, because monthly returns follow more or less what is known as a normal distribution, popularly known as a "bell-shaped" curve. One of the properties of such a distribution is that you know that 95% of the time, returns will be comprised between average +/- 2 standard deviations. 67% of the time, returns will be comprised between average +/- 1 standard deviation. For detailed calculations, you can go to our "Calculations" page. Of course, past volatility is no perfect predictor of future behaviour, but the information provided by standard deviation is too important to be overlooked. Another limitation of volatility is that, if you hold several funds, you can average the returns, but not the volatility: the aggregate volatility is likely to be lower than the average of the various funds individual volatilities. That is the benefit of diversification.
