Understanding the risk associated with an equity investment

Last Updated on August 30, 2021 at 4:16 pm

When returns fluctuate wildly it is important to not only measure ‘average’ return (CAGR or XIRR), but also to measure risk – that is, quantify the fluctuations.

The simplest way to do it is to calculate the standard deviation and best non-technical illustration of the same is from Subra:

Rahul Dravid’s individual score will typically be close to his average – Low standard deviation. Example, debt mutual funds

Virender Sehwag’s individual score can just about be anything! High standard deviation.Example, gold, stocks, equity mutual funds.

Here is a 3-minute video on what the standard deviation is and how it can be used to measure risk associated with an equity investment.

I strongly believe that understanding standard deviation is the key to successful mutual fund investing.

It is a fantastic way to select mutual fund categories suitable for your financial goals

Although useful to get a sense of volatility, the standard deviation is too simplistic to make predictions. So one should use it with care/caution.

I have written several posts about standard deviation. Here are a few:

Visualizing Mutual Fund Volatility Measures

Mutual Fund Investing: Risk vs. Reward vs. Volatility

What Return Can I Expect From Equity Over the Long-term? (Part 2)

Here are two screenshots of the performance tab at Value Research: standard deviation and average monthly return over the last 3Y are listed here.

The risk & rating tab at MorningStar where the standard deviation is listed along with the CAGR.

Higher the standard deviation, higher the volatility. This is reason why Gold is riskier than Stocks!