Standard Deviation in Mutual Funds - Meaning, Explanation, Formula & Example

When it comes to investing in MFs through Systematic Investment Plans (SIPs), many investors primarily focus on returns. However, to make informed investment decisions, it is crucial to understand and assess the associated risks. One key metric often used by Fund Managers and well-informed investors alike is 'Standard Deviation'. This blog will delve into the concept of Standard Deviation; particularly in the context of SIP investments, helping you better understand this crucial statistic.

Understanding Standard Deviation

So, what is the Standard Deviation? Simply put, the Standard Deviation is a statistical measure indicating an MF's return volatility. It shows how much a fund's returns deviate from the average or expected returns. Standard Deviation is not just limited to finance, but also widely used in various fields to gauge variability.

In MFs, a higher Standard Deviation implies greater volatility, meaning the fund's returns can vary more significantly from its average returns on SIP. Conversely, a lower Standard Deviation indicates that the fund's returns are more consistent and less prone to wide fluctuations.

The Relevance of Standard Deviation in SIP

When investing through SIPs in MFs, understanding the Standard Deviation of a fund can be particularly useful. SIPs involve regular, fixed investments over a period and knowing the fund's volatility can help investors align their investments with their risk appetite.

For example, if you prefer a less risky investment, you might choose a fund with a lower Standard Deviation. On the other hand, if you are comfortable with a higher risk for potentially higher returns, a fund with a higher Standard Deviation might be more suitable.

How does standard deviation work?

Standard deviation helps you measure how much the returns of a mutual fund can vary from its average return over time. If it is high, it indicates that the fund’s return can fluctuate a lot and showcases a higher risk. If the deviation is low, it means better performance and low risk.

Standard Deviation Formula

The Standard Deviation is calculated using a specific formula. The formula involves comparing each individual return of the fund over a certain period, with the average return for that period. The more the individual returns deviate from the average, the higher the Standard Deviation.

Example of Standard Deviation in Mutual Funds

To illustrate, let's consider an example. Suppose an MF has had the following returns over four months:

• September: 14%

• October: 8%

• November: 9%

• December: 6%

First, we calculate the average return through mutual fund calculator over these months. Then, we use the Standard Deviation Formula to determine how much each month's return deviates from this average. The resulting percentage gives us the Standard Deviation of the fund for this period.

Comparing Standard Deviation in Mutual Funds

The term standard deviation assists investors to understand the volatility of a mutual fund. If there is a higher standard deviation, it means that the fund’s returns can fluctuate more which means more risk and vice-versa.

Let us take an example to help you make informed choices.

The table shows that Fund B is more volatile than both its category and benchmark, while Fund A shows moderate deviation. Comparing these figures helps assess risk tolerance before investing.

Importance of Standard Deviation in Risk Assessment

Understanding Standard Deviation is crucial for risk assessment in MF investments. A fund with a high Standard Deviation can experience large fluctuations in returns, which might not be suitable for risk-averse investors. Conversely, a fund with a low Standard Deviation might offer more predictable returns, though potentially lower.

The 68-95 Rule and Standard Deviation

A useful concept in understanding Standard Deviation is the 68-95 rule. This rule states that in a normal distribution, about 68% of observations fall within one Standard Deviation of the mean and about 95% fall within two Standard Deviations. This rule can help investors estimate the range within which a fund's returns are likely to fall in the future.

Drawbacks of relying solely on Standard Deviation

While Standard Deviation is a valuable tool for assessing risk, it shouldn't be the only factor in investment decision making. Factors like market conditions, fund management strategy and your personal investment goals also play crucial roles.

Balancing Standard Deviation with other measures

A balanced approach to risk assessment involves considering other measures alongside Standard Deviation. Tools like the Sharpe ratio, beta and alpha provide additional insights into a fund's performance and risk profile.

Practical Applications of Standard Deviation in SIP investments

To further enhance your understanding of how Standard Deviation plays a role in SIP investments, let's delve into some practical applications. Knowing the Standard Deviation of MFs can significantly influence your SIP investment strategy.

1. Tailoring SIPs to Risk Profiles

By understanding the Standard Deviation, you can tailor your SIP investments to match your risk profile. For instance, if you're nearing retirement, you might prefer funds with a lower Standard Deviation, signifying less volatility and more predictability in returns. Conversely, if you're a young investor with a long-term horizon, you might be more inclined to invest in funds with a Higher Standard deviation, leveraging the potential for higher returns despite the increased risk.

2. Diversification Strategy

Standard Deviation also plays a crucial role in diversification. By selecting funds with varying levels of Standard Deviation, you can create a diversified portfolio that balances risk and return. This approach ensures that your investments are spread across different risk categories, potentially levelling out the overall volatility of your portfolio.

3. Market Trend Analysis

 Understanding the Standard Deviation of funds during different market cycles can provide insights into how certain funds react to market conditions. For example, during a market downturn, a fund with a historically lower Standard Deviation might be expected to experience less severe fluctuations compared to a fund, with a higher Standard Deviation.

4. Informed SIP Adjustments

Regularly monitoring the Standard Deviation of your SIP investments allows you to make informed adjustments. For instance, if a fund's Standard Deviation increases significantly over time, it might prompt a review of your investment in that fund, considering whether it still aligns with your risk tolerance and investment objectives.

5. Benchmarking Performance

Lastly, Standard Deviation is invaluable in benchmarking the performance of MFs. By comparing the Standard Deviation of a fund to its peers and benchmarks, you gain a clearer perspective on whether the fund is performing within expected risk parameters.

How Can Investors Use Standard Deviation to Choose Mutual Funds?

As an investor, you can make use of standard deviation to analyse the risk level of mutual funds. A fund that shows a high standard deviation often has an unpredictable return and may be suitable for aggressive investors. On the other hand, a low standard deviation indicates stable returns, ideal for conservative investors. Comparing a fund’s standard deviation with its category average or benchmark helps determine if it’s riskier than peers. It also helps evaluate if higher returns are worth the added volatility. 

How to Interpret Standard Deviation for Portfolio Selection?

When building a mutual fund portfolio, standard deviation helps investors balance risk and return. A high standard deviation means a fund is more volatile, which can lead to higher returns but also bigger losses.

Low standard deviation funds provide more predictable returns and add stability. Investors should compare standard deviation values across different funds and combine high- and low-risk investments based on their goals. It’s also helpful to compare a fund’s deviation with benchmarks to check its performance in different market conditions. It helps create a well-diversified and suitable investment portfolio.

Standard Deviation as a Guide in SIP investments

Understanding Standard Deviation is a vital aspect of investing in MFs through SIPs. It provides insight into the volatility and risk associated with a fund, helping you align your investments with your risk tolerance. ICICI Bank offers a wide range of MF investment options with detailed risk assessments, including Standard Deviation, to assist you in making informed investment decisions. Remember, while Standard Deviation is an important tool, it works best when used in combination with other investment assessment methods.