Discuss the use of standard deviation as a risk indicator for investment purposes.

Introduction:

These article discuses the use of standard deviation as risk indicator for investment but first,

the paper will seek to define certain key terms for the purpose of clarity.

Standard Deviation:

Standard Deviation is defined as a measure of dispersion of a data set from the average. If the

difference between the closing prices and the average price is larger, there would be a higher

the standard deviation, and thus higher volatility while the closer the closing prices are to the

average price, the lower the standard deviation and volatility.

Standard deviation can be used to determine the annual rate of return of an investment to

determine volatility, or risk. Traders Log (2009)

Black, (2004) the lowercase Greek letter sigma in standard deviation is often noted as ,
σ

that is, the square root of the sum of the squared differences of each return relative to the

mean return, divided by sample size (Number of scores) minus 1. The formula for standard

deviation is calculated as:

Standard Deviation as a measure of risk:

The standard deviation is often used by investors to measure the risk of a stock or stock

portfolio. Measuring risk may be easy to understand by most individuals, where risk could be

defined as the chance of losing your investment forever and to others, a chance of losing

more than 30% for a month or longer and lastly to others, a stock considered too risky to keep

one up all night.

Furthermore, there is no perfect way to measure risk yet several decades of academic

research, investors and analysts use standard deviation as their main measurement of risk.

Krantz (2008).

In contrast, Sumnicht (2009) states that when attempting to develop an optimally allocated

portfolio of investments, using standard deviation as definition of risk leads to unreliable

conclusions when ones’ objective is to avoid risk. He further states that using standard

deviation as a measure of risk assume a symmetrical return distribution where the unexpected

gains are as risky as unexpected losses.

Uses of standard deviation as risk indicators:

Trade10 (2008) states different uses of standard deviation; First of all, it measures

variation of expected return, that is, standard deviation can be used to measure the

variation of expected return which has taken place in the past. This then gives a sense of

range of performance that can be expected with different probabilities of return for the

future.

Also, standard deviation is used in technical analysis. This way, it is used in the

construction of Bollinger bands so that during times of lower volatility, it contracts as the

range of prices during the period being used for data points gets smaller, reflecting lower

volatility and when it increases, the standard deviation lines widen. This technique was

developed by John Bollinger for looking at expected future price projections and potential

reversal points. In addition, the standard deviation measures risk of security, given that,
the smaller the standard deviation, the tighter the probability distribution, and the lower the

risk associated with the security.

Again, it measures the variability and volatility of data. In this way, standard deviation can

be used to measure the variability or volatility of any data set. If data points are normally

dispersed then the standard deviation will give the probability of future data points falling

within a certain range of the current mean. This allows for risk assessment which

compares the data sets of various securities.

Furthermore, it possesses useful mathematical properties on returns of all possible assets.

That is, if one can estimate the standard deviation of returns from all possible assets and

covariance’s of returns between assets, and then we can find the standard deviation of returns

from any portfolio. (Phillp B. et al, 2005)

And finally, standard deviation is able to predict performance, during evaluation; this can be

done when analysts use this measure to predict how a particular investment or portfolio will

perform. The range of investment's possible future performances based on a history of past

performance is calculated where the probability of meeting each performance level within

that range is estimated. (Scottrade, 2009)

Limitations of the use of Standard Deviation as a risk indicator for investment:

However, even if to most investors considering standard deviation as the most acceptable risk

measurement tool, it is considered not perfect.

Traulsen (2007) states that standard deviation fails to capture risk from current portfolio.

Given that it is a statistical measure, based on a fund's past performance it may well fail to

capture risks that are in the fund's current portfolio that have not been shown in the fund's

past performance. For example, a fund that has typically been well diversified across market
sectors in the past, but that now has 75% of its assets in technology stocks would be expected

to behave quite differently in the future than it has in the past.

On the other hand, Sortino et al, (2001) states that it’s underlying data, which has a “bell

shaped curve” forms a ground for all its assumptions. This argument follows that if the

underlying data is not normally distributed then the standard deviation is likely to give a

misleading result and all things being equal, most investors will prefer less volatile returns to

more volatile returns. However, in reality not all things are usually equal and therefore the

deficiencies of standard deviation as a risk measure begin to surface.

In addition, they show that if investment return is non-stationery as many market participants

believe, the process will be ergodic. This is where its ensemble statistics are always different

from the true ensemble standard deviation at a fixed point in time leading it to be

unsatisfactory as a measure of uncertainty yet alone risk.

Still, it continues with the argument stating that in the presence of non-linearity’s, such as

options and non-linear trading and portfolio management strategies, investment return

distributions can become markedly distorted away from a normal distribution. To illustrate

this, they supported their arguments with Bookstaber and Clarke (1985) which states that

“using standard deviation as a proxy would appear to show that covered call writing is

preferable for risk detection than to buying puts which are inferior to stocks-only portfolio”.

Therefore, the variance or standard deviation is not a suitable proxy for risk in these cases

because option strategies reduce variance asymmetrically.

Also, standard deviation fails to forecast risk. This is where it captures the variability of an

investment’s return around its average, so when standard deviation increases, the risk of

variability in returns also increases. For example, even during the recent financial crisis,

standard deviation did not forecast the risk, all reflected increased risk once the crisis had hit.

Kaplan et. al (2009)

Next, Sumnicht (2009) further argues that the use of standard deviation as a measure of risk

assumes all investment returns follow a bell-shaped (symmetrical) curve. However, rarely

does any investment return distribution look like a classic “bell curve.” Plotting most

investment return distributions show the graph being skewed positively or negatively.

Feibel , J. (2003) states that there are two major criticisms of the standard deviation approach

as risk measurement. The first is that the centre where the standard deviation is calculated is

the mean historical return. This return is regarded as the measure of the average return. The

standard deviation treats as a contribution any returns that fall on either side of the mean

return. However, investors may have a different focal point for riskiness that is if an investor

has had a mean annual return of 15%. To reach its goal, it might expect to earn 9% per year

so in this case one would consider annual returns below 9%, not 15%, as risky.

Secondly, the standard deviation treats positive and negative return deviations from the mean

with equal weight which may be regarded counterintuitive that returns that are above the

average return should make a positive contribution towards a measure of riskiness. For

example, if ones average monthly return of an investment is 5% and there comes a month

where 13% investments return is made instead, one might consider this fortuitous rather than

risky but the 13% return will have the same impact as -13% return on standard deviation of

return.

And finally, standard deviation rewards consistent losers and continues to punish high

performers. That is, if the fund is a consistent poor performer or a consistent high performer,

its standard deviation will be low. When measuring risk one must use standard deviation but

one should complement this risk measurement by also looking at a fund's consistency over a

few calendar years. Levine (1998)

Conclusions
Though there are numerous advantages and limitations of Standard Deviation as stated above,

but until someone invents a better way to measure risk, it will remain the best and easiest way

to measure risk for investment purposes since it has relatively shown to do a good job in

applying risk indicator models to real life applications.

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