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Average height, average IQ, average sleep cycle… the problem with average is that it doesn’t tell the whole story. Memphis and Los Angeles, for example, share very similar average temperatures, but Memphis residents are accustomed to lows in the 30s, a cold that most LA residents find frightful. Average investment returns are no different as they do little to describe an investment’s range. Rather than relying on average returns alone, refer to an investment’s Standard Deviation to get a better feel for its highs and lows before committing.
Standard deviation is the most widely used measure of price range or volatility. It measures the variance of an investment’s returns around its average. An investment with an average return of 7% and a standard deviation of 12% has experienced returns between -5% (7% minus 12%) and +19% (7% plus 12%), 68% of the time. 95% of the time, it has experienced returns between -17% and +31%, which is the average plus or minus two standard deviations (12% x 2, or 24%). An investment with a low standard deviation experiences smaller fluctuations in price (lower volatility) compared to one with a larger deviation.
Understanding standard deviation is important in determining if an investment is right for your risk tolerance and/or cash flow needs. If the downs are too down for your taste, there is a higher risk of acting irrationally and selling at a low. Additionally, if volatility is too high, there is greater chance of selling an investment when you need it, for less than what was paid. So, while the metric itself doesn’t provide the risk of an investment becoming worthless, it does shed some light on the possibility of experiencing a loss driven by emotion or circumstance.
