Standard Deviation as a Risk Indicator for Investment Purposes

Standard deviation as a risk indicator for investment purposes

“Investments are risky. Investors must be able to intelligently analyse risky assets to determine the estimated rate of return expected and make a judgement about risks versus returns.” (Amling, 1989, p4) Amling goes on to state that, “understanding and measuring risk is fundamental to the investment process.” (1989, p23) The aim of this paper is therefore to look at how standard deviation performs as a risk indicator and how useful it is for the investor in judging risk for investment purposes.

It is stated that, “Risk is concerned with the uncertainty that the realised return will not equal the expected return. Emphasis is on the extent to which the return may differ from the average return or on volatility of the return. The former may be measured be a statistical concept called the standard deviation.” (Mayo, 1988, p143) Standard deviation is used for this purpose as, “instead of measuring the probability of a number of different possible outcomes, the measure of risk should somehow estimate the extent to which the actual outcome is likely to diverge from the expected outcome.” (Sharpe & Alexander, 1990, p145) Standard deviation allows for this as it estimates what is going to be the probable divergence of a return from what is expected. (Sharpe & Alexander, 1990, p145)

As there are some securities that, the more speculative they are, the higher the returns and therefore the risk, giving investors the requirement for a greater analysis and management of what is expected in terms of risk and returns. (Amling, 1989, p23) This results in, “why the standard deviation of returns is used as an estimate of risk.” (Amling, 1989, p23) For one reason, as Matt Krantz puts it, “standard deviation is a readily available and easily understood statistic that measures how often an event strays from the norm.” (http://abcnews.go.com)

“The standard deviation of the rate of return (σ) is a...