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By Wendy Stein and Christian Charest | 07-17-2017

The Morningstar Dictionary: Standard Deviation

This popular measure gives investors a sense of how volatile a fund's performance has been.

Wendy Stein: No concepts are more fundamental to investing than risk and return. And when it comes to risk, the most widely used measure to determine the investment risk level of mutual funds and ETFs is standard deviation.

So what is it? Well, in technical terms, standard deviation measures the dispersion or spread of a fund's returns around its average return over a certain period of time.

At Morningstar, standard deviation is computed using trailing monthly total returns for the appropriate time period, 3, 5 or 10 years. All of the monthly standard deviations are then annualized and it's expressed as a percentage.

It gives you a sense of how volatile a fund's performance has been in the past so that you can use it as an indicator of how volatile it might be going forward.

When a fund has a high standard deviation, the predicted range of performance is wide, so it could be a bumpier or more volatile ride compared to another fund with a lower standard deviation.

Suppose we take a simple example of two mutual funds and look at their annual rates of return over the course of five years. They both have an average return of 5%, but Fund 1 will have a higher standard deviation than Fund 2 because the spread of returns from the average is much greater than for Fund 2, where the annual returns really hug the average. As an investor, you can look at this and reasonably predict that Fund 1 will be a more volatile investment than Fund 2.

Let's take a real life example now, Mawer Balanced Fund. In the Volatility Measures section of the Rating and Risk tab of this fund's Morningstar report, we see that this fund's 3-Year Standard Deviation is 6.33% versus the average fund in its category which is 6.43%. This fund should have a slightly less bumpy ride than the average fund in its category.

An important point to remember though is that standard deviation is an indicator of the volatility of returns but it does not measure investment risk as most investors perceive it. Why? Because for most investors, investment risk is the potential for losing money. And with standard deviation, returns that are above their average increase the standard deviation the same way as returns that are below the average. And, as a result, standard deviation punishes positive performance. It seems odd that positive returns, could make a fund riskier, but that's exactly the effect that they have. On the contrary, earning positive returns is the whole point of being an investor.

This is the reason Morningstar's risk-adjusted measures, such as the Star Rating, don't use standard deviation as their measure of risk; rather, they use a proprietary formula that only punishes below-average performance.

For Morningstar, I'm Wendy Stein.