Using the Standard Deviation To Measure Your Investment Risk

Most people focus on the average returns of their investments. But an average, by its nature, hides the fluctuations. If you are going to use a Retirement Income Calculator or a Retirement planning Spreadsheet you should really try to understand risk measurements.

One great way to measure the risk associated with investment returns is the standard deviation. The standard deviation sounds complicated, but just focus on the last word: deviation. We all know what that is.

The simple explanation is that a standard deviation tells you how likely it is that your returns will fall within a specific range. It does this in the same units as your mean. This is great because with some simple math, you can pretty easily conceptualize your level of risk. For instance, I pulled the unofficial returns for the Standard and Poor 500 between 2000 and 2009.

The average return was calculated at -0.61%. To clarify, this is a negative 6/10ths of a percent. The standard deviation was 20.63%. Which means that about 68% of the time the annual return should fall between (-0.61 + 20.63%) and (-0.61% - 20.63%), or 20.02% and -21.24%.

About 95% of the time the return should fall between (-0.61% + (20.63% X 2) and (0.61% - (20.63% X 2), or 40.65% and -41.86%.

This logic fits our returns well. The annual returns from 2009 to 2000 are:

23.5%, -38.05%, 3.5%, 13.6%, 3.0%, 9.0%, 26.4%, -23.4%, -13.0%, and -10.1%

Does this help?