Here’s why looking at a stock’s standard deviation is critical for investors

Nick Sundich Nick Sundich, November 29, 2023

A stock’s standard deviation is not something that many investors tend to look, even some professional investors. It is slightly more common to look at a portfolio’s standard deviation. Our aim in this article is to convince you that you should pay more attention to it, just as is the case with other metrics. We will outline just what this metric is and how to interpret it.

 

What is Standard Deviation and what is its relevance in stock investing

Speaking generally here, Standard deviation is a statistical metric that measures the amount of variability or dispersion of a set of data values from their average. In other words, it tells us how much the data points deviate or differ from the mean. It is a widely used tool in various industries, including finance, to measure risk and volatility.

In the world of stock investing, standard deviation plays a crucial role in helping investors analyse and understand the potential risks associated with their investment decisions. It is an essential tool for both individual investors and financial institutions to evaluate investments, create portfolios and make informed decisions.

 

How to calculate it

To fully grasp the relevance of standard deviation in stock investing, it’s important to understand how it is calculated. There are three steps:

1. Calculate the mean (average) of the data set
2. Find the difference between each data point and the mean
3. Square those differences, sum them up, and divide by the total number of data points

The resulting value is known as variance, and to find the standard deviation, we simply take the square root of the variance. Once calculated, investors have a measure of how much the data points deviate from the mean, with higher values indicating more significant deviations and thus, higher variability.

This is a very simple calculation, we admit. There are other websites that can provide a more comprehensive breakdown, and perhaps even calculate for you.

 

Why is this metric important in stock investing?

Stock investing, by its very nature, involves risk. Investors put their money into a company’s stock in hopes of gaining a return on their investment. However, there is always the possibility of losing money if the company’s performance does not live up to expectations. This is where standard deviation comes in.

Standard deviation allows investors to gauge how volatile a stock’s price has been historically and provides insight into potential future volatility. A higher standard deviation indicates that the stock has experienced significant fluctuations in price, making it riskier. On the other hand, a lower standard deviation suggests a more stable stock with less variability in price.

 

Using Standard Deviation to build portfolios

Another essential aspect of stock investing is portfolio diversification. A diversified portfolio helps mitigate risks by spreading investments across different assets and industries. Standard deviation plays a vital role in this process as well.

Investors can use standard deviation to determine the level of risk in their portfolio and make adjustments accordingly. A portfolio with a higher standard deviation means that it is more volatile and carries higher risk, while a portfolio where this metric is lower indicates a more stable investment. By using this information, investors can rebalance their portfolios to achieve their desired level of risk.

 

Final thoughts

In conclusion, standard deviation is a crucial tool in stock investing that helps investors analyse and understand the risks associated with their investments. It provides valuable insights into the volatility of stock prices and can be used to build diversified portfolios. As such, it is essential for investors to have an understanding of this metric and use it as part of their investment decision-making process.

So, it is always advisable to consult a financial advisor who can help interpret metrics like this and guide investors in making informed decisions. Happy investing!

 

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