Understanding Standard Deviation Helps You Have A More Realistic Performance Expectation.
Until you understand standard deviation (Std. Dev.), you might make the mistake of selecting mutual funds based solely on a high average annual rate of return.
The problem with choosing mutual funds based solely on a high average annual rate of return is that you may have the wrong expectation going forward.Std. Dev. is a measure of how much a mutual fund's annual return deviates from the fund's historical average return.
In other words, "how much higher" and "how much lower" than it's historical average did this fund's annual return vary during a specified time period? Unlike beta, Std. Dev. is a measure of a fund's absolute volatility.
Statisticians say that returns will fall within one Std. Dev., 67% of the time, and within two Std. Dev.'s, 95% of the time.
So, say you are looking at a mutual fund with a historical average annual return of 10%. And, it has a Std. Dev. of 15%.
What this tells you is that... this fund probably (67% of the time that is) earned somewhere between -5% to +25% (that is 10% plus 15% or 10% minus 15%).
And, it almost certainly (95% of the time that is) earned somewhere between -20% and +40% (that is 10% plus 30% or 10% minus 30%).
Even though our example fund provided an average annual return of 10%. It did not earn 10% each and every year. Some years it did better than 10% and some years it did less than 10%.This is why you should not select mutual funds based solely on a high average rate of return.
Virtually any mutual fund will not provide the average annual return every single year. In fact, nearly all funds can and will lose money in some years.
So, the idea is to look for funds with lower Std. Dev.'s compared to other funds in the same category. The lower the standard deviation, the better.
"Because It Matters"... Jim
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