Standard Deviation

Standard Deviation is a statistical term that, in the world of finance, has become the go-to shorthand for measuring an investment's volatility. Think of it as a number that tells you how much a stock's or fund's returns have historically bounced around its average return. A low standard deviation suggests a smooth ride—the returns have been consistent and stayed close to the average. A high standard deviation, on the other hand, signals a roller-coaster journey, with returns swinging wildly, both up and down. This metric is a cornerstone of Modern Portfolio Theory, where it is often used as a direct proxy for Risk. The core idea is simple: the more an asset's price jumps around, the riskier it is considered to be. However, as we'll see, a savvy value investor knows that volatility and risk are two very different beasts.

Imagine two stocks, “Steady Eddie Inc.” and “Wild Wendy Co.”

• Steady Eddie Inc. returns an average of 8% per year. Most years, its return is very close to that 8%, maybe 7% one year and 9% the next. Its returns are tightly clustered around the average. This stock would have a low standard deviation.
• Wild Wendy Co. also returns an average of 8% per year. But it achieves this average in a much more dramatic fashion: down 20% one year, up 45% the next. Its returns are spread far and wide from the average. This stock would have a high standard deviation.

Statistically, if an investment's returns follow a Normal Distribution (the classic “bell curve”), about 68% of its annual returns will fall within one standard deviation of the average, and 95% will fall within two. So, if a fund has an average return of 10% and a standard deviation of 15%, you could statistically expect its returns to be between -5% (10% - 15%) and 25% (10% + 15%) about two-thirds of the time.

While academia and Wall Street often equate high standard deviation with high risk, value investors have a radically different viewpoint.

The legendary investor Warren Buffett famously stated, “Risk comes from not knowing what you're doing.” For a value investor, the true risk is not that a stock's price wiggles up and down; it's the risk of a permanent loss of capital. This happens when you overpay for a business or when the underlying business itself deteriorates. From this perspective, volatility isn't the enemy; it can be your best friend. The mood swings of Mr. Market create price fluctuations (volatility). When the market panics and sells off a wonderful business for irrational reasons, its price drops and its measured standard deviation might increase. For the uninformed, this signals “danger!” For the prepared value investor, it signals a potential opportunity to buy a great company at a significant discount to its intrinsic value. In short, you don't fear the roller-coaster; you wait for the dips to get on board.

Standard Deviation is a tool, and like any tool, it's useful only when you understand its purpose and its limitations.

• What it tells you:
  1. Historical Volatility: It provides a neat summary of how jumpy a stock's price has been in the past.
  2. Relative Stability: It's useful for comparing the historical price behavior of two different assets (e.g., a utility stock versus a biotech startup).
• What it doesn't tell you:
  1. The Future: It is a backward-looking measure. A company's placid past performance doesn't guarantee a calm future, and vice versa.
  2. The Difference Between Good and Bad Volatility: Standard deviation treats all deviations from the average as equal. A sudden 50% surge in price is treated the same mathematically as a 50% crash. As an investor, you feel very differently about these two events! (More advanced metrics like the Sortino Ratio try to fix this by only focusing on negative, or “bad,” volatility).
  3. Business Quality: A stock can have a very low standard deviation simply because it is unloved, ignored, or slowly drifting toward zero. A worthless company can be very stable on its way to bankruptcy.

Standard Deviation is a measure of past price volatility, not a true measure of investment risk. As a value investor, your job is to separate the two. Use it as a thermometer to gauge the market's feverish sentiment, but never as a compass to guide your investment decisions. Your compass should always be a deep understanding of the business, a conservative estimate of its value, and the discipline to only buy with a substantial margin of safety. When others see a high standard deviation and panic, you should see the potential for opportunity.