You may have hated Maths in your school days, but now since you are on the path to becoming a value investors, you need to grip some numbers related to stocks or mutual funds that you intend to buy. These terms or concepts are very vital to understand the inherent risk and return associated with investments.
• Standard Deviation
• Sharpe Ratio
• Treynor Ratio
Standard deviation simply quantifies how much a series of numbers, such as fund returns, varies around its mean, or average. Investors like using standard deviation because it provides a precise measure of how varied a fund’s returns have been over a particular time frame both on the upside and the downside.
With this information, you can judge the range of returns your fund is likely to generate in the future.
The more a fund’s returns fluctuate from month to month, the greater it’s standard deviation.For instance, a mutual fund that gained 1% each and every month over the past 36 months would have a standard deviation of zero, because its monthly returns didn’t change from one month to the next. But here’s where it gets tricky: A mutual fund that lost 1% each and every month would also have a standard deviation of zero.
Why? Because, again, its returns didn’t vary. Meanwhile, a fund that gained 5% one month, 25% the next, and that lost 7% the next would have a much higher standard deviation; its returns have been more varied.
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Standard deviation allows a fund’s performance swings to be captured into a single number. For most funds, future monthly returns will fall within one standard deviation of its average return 68% of the time and within two standard deviations 95% of the time.
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