Financial Terms Part 3 - Average and Standard Deviation

In this series of Knowing Basic Financial Terms, we will look at the meaning of averages and standard deviation. Average is quite simple to grasp.

For example, if you invest in $5,000 each in 2 stocks, stock A give 10% return and stock B gives 12% return, your average return is 11%. Here comes the danger is you just take the average return to make a decision on investment. Based on the assumption above, it seems stock B is a better choice of investment, but is it so?

Let’s look a bit deeper.

While stock B gave an average return of 12% a year over a 2 year period, you do not know what happen during that period. Stock B’s return could have wildly fluctuated. One year it could have been 40% and another year it could have been -16%. The average would be 12%.

Assuming stock A on the other hand returns have been 14% and 6%, then A average return is 10% but with much less fluctuation. Such fluctuation can be measured statistically using a term called Standard Deviation i.e how much is deviates from the average.

Stock B has a standard deviation of 28% while stock A has a standard deviation of only of 4%. So stock B is expected to give a return of 12% (plus or minus 28%) and Stock A is expected to give 10% (plus or minus 4%). The question here is, is the risk worth the additional 2% return? Only you can answer it for yourself.

The same thing applies to funds that you invest in. Most funds would have the standard deviation listed along side the its 1, 3 or 5 years average returns.

So the next time someone comes out and tell you about how great a fund is and the average returns, you next question should be what is the standard deviation.

Point to note : a 6 foot person can drown crossing a river that has an average depth of 5 feet.