Pop quiz: Investment X and Investment Y have each returned 10% over the last 5 years. Which one is better?
It is tempting to claim neither, as their returns are equal. But how does your response change if we also provide this fact: Investment X went up slowly and steadily each year, while an investment in Y was a wild ride – down 10% in two of those five years. Our guess is that most people would strongly prefer Investment X with this new information. The moral: when evaluating investments, one must assess both returns and risk together.
Standard deviation is a unit of measurement commonly used to represent investment risk, but we find that it frequently creates confusion for our clients. However, it is a simple and important concept that all investors should understand.
What is standard deviation?
If you are interested in learning how to calculate standard deviation, or are interested in its statistical properties, feel free to check out its Wikipedia entry.
Our aim here is to explain what standard deviation means with respect to investing and why you should care. Standard deviation is used as a gauge of investment risk, and relates to the volatility – the degree of fluctuation – of investment returns.
Take a look at the chart below. This chart plots the annual performance of two investments, A (blue), and B (orange), each year from 2009 to 2015. Investment A has returns that range from –19% to 29% while Investment B has returns that range from -3% to 9% over the same period. The returns of investment A are significantly more volatile than those of Investment B. Therefore, A will have the higher standard deviation of the two investments.
Does volatility = risk?
Above, we explained that the higher the volatility of returns, the higher the standard deviation. This begs the question, does volatility = risk? In other words, why should anyone care about the degree to which an investment fluctuates in value?
Many investment professionals, including some of our favorites (Mr. Buffet), have said that volatility does not equate with investment risk. Their logic is that for a long-term investor who stays the course and remains disciplined, the magnitude of short-term portfolio fluctuations should be of little concern.
We agree with this in theory; however, we have learned from 20+ years of advising clients that volatility does matter, for both emotional and economic reasons. In short, most people 1) do not have Warren Buffett’s investment discipline and make poor buy/sell decisions as a result, and 2) do not have the ability (regardless of discipline) to withstand massive portfolio losses without it impacting their expected retirement age or financial goals. Losing sleep or experiencing severe anxiety/stress from fluctuations in your net worth can be just as damaging as any monetary loss.
These two factors – ability and willingness to take risk – are the basis for deciding whether to invest conservatively or aggressively, and standard deviation is the primary metric we use to measure the level of risk.
Finally, standard deviation is not the only measure of risk. We consider many different metrics when evaluating investment risk, and for some types of investments, standard deviation can be misleading. However, we believe that standard deviation is a helpful risk measurement when assessing multi-asset class portfolio returns.
Is lower standard deviation “better”?
It depends. For a given level of return, lower standard deviation is better. This relates to our initial question: would you rather have an investment that gives you a steady and predictable amount of return for ten years, or one that is highly volatile during that period but with the same result? We think the answer is clear.
But when it comes to investing, risk is not a four letter word. Risk must be taken in order to achieve returns. So an aggressive portfolio of all stocks should expect a materially higher standard deviation than a conservative portfolio of bonds, even if their returns are similar over a short term period. All that matters is that you are taking on an appropriate amount of risk to meet your goals, and are aware and comfortable with that risk.
My portfolio has a standard deviation of 8. What does that mean?
Don’t focus on the number in a vacuum – use indices to put it in perspective. Any presentation of standard deviation should be accompanied with the standard deviation, over the same time period, of relevant indices for stocks and bonds. If you are expecting your portfolio to be conservative in nature, but its standard deviation compares more closely to the S&P 500 than a US Treasury bond index, that’s a problem.
The bottom line
- Too often, the press and client reporting focuses on returns alone. We think this is bad practice. Investments must be evaluated on the basis of risk-adjusted return. For the purpose of portfolio construction, we believe standard deviation is the best proxy for risk.
- There is no such thing as a “good or bad” level of standard deviation. All investments have risk, and an aggressive investor should expect a much higher standard deviation than a conservative investor. What matters is that your portfolio reflects the degree of risk that you desire and expect.