Understanding the risk associated with an equity investment

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.

yH5BAEAAAAALAAAAAABAAEAAAIBRAA7 - Understanding the 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.

Standard-deviation-VR
At Value Research

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

At MorningStar
At MorningStar

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

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