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.
