Introducing You To Standard Deviation

WE'VE TALKED ABOUT other ways to measure the volatility of a given investment. One widely used measurement is beta, which measures how volatile a stock or stock fund is compared with the rest of the stock market. If a fund's beta is 1, it is just as volatile as the overall market—usually as measured by the Standard & Poor's 500-stock index. If the fund's beta is 2, it is twice as volatile as the overall market.

How would this work in practice? Take one widely held stock fund—the T. Rowe Price Equity Income Fund. Equity income funds seek both capital appreciation and income, so they invest mostly in stocks that offer some potential for appreciation and also pay decent dividends. Since it is mostly the more conservative funds that pay dividends, you'd be right in assuming this fund invests in conservative stocks. Since the fund invests in conservative stocks, you would also be right in assuming it had a fairly low beta. In fact, according to Morningstar, the fund recently carried a beta of 0.58. That means it is barely half as volatile as the S&P 500.

Now take another fund from the same family—the T. Rowe Price Science & Technology Fund. As the name implies, the fund invests primarily in technology stocks. And, if you didn't know it before the technology bubble popped in 2000, such stocks tend to be very volatile. That being the case, you would assume that the fund has a high beta. In fact, its beta recently was 2.34. That means it is 2 1/2 times as volatile as the S&P 500.

You consider the beta of every investment you make, so you know how volatile of a portfolio you are building. The essence of keeping cool is not having too many stocks that are highly volatile. Think twice before you buy funds (or stocks) with betas higher than 1.

So beta is one aspect to consider when investing. Keep your beta relatively low and you'll be better able to ride out whatever turbulence the markets throw your way. You'll find the beta for every fund reported by Morningstar, and by just about everyone else that rates funds.

So What Is Standard Deviation All About?

But there's also something else you must consider when you invest: how much exposure to potential loss you have with each investment you make. The yardstick there is called "standard deviation". It is the most widely used measure of the amount of risk of any investment. It isn't the easiest concept in the world to understand—but understanding it can help you keep cool no matter how turbulent the world gets.

Standard deviation is a mathematical concept. If you search for it on the Internet, you'll find no end of complicated mathematical formulas and symbols. Let's skip past the math and explain it as simply as possible.

Put most simply, standard deviation measures the amount of variation from average in a group of numbers. Those numbers could be the weights of all the players on your favorite pro football team. They could be the ages of your children. Or they could be the returns over time of a mutual fund. Whatever you are measuring, the average is the "standard". Deviation is the degree to which those numbers range on either side of standard. Put them together and you get standard deviation.

Take standard deviation as it applies to the ages of children in two different families. Say that there are three children in both the Allen family and the Brown family. The three children in the Allen family are age 8, 10 and 12. The three children in the Brown family, being triplets, are all age 10. What is the standard deviation of each?

The average age of the Brown triplets is 10. Since all three are age 10, there is no deviation—meaning that the standard deviation is zero. The average age of the Allen children is also 10—which you learn by totaling their ages (8, 10 and 12) and dividing by three. But two of the kids—the eight-year-old and the 12-year old deviate from the average. The degree to which the actual ages of the Allen kids deviate from the average is the standard deviation. There's a mathematical formula you'd use to measure that deviation. To save you the math, it comes out to 1.63. If the Allen kids were 1, 9 and 20, their average age still would be 20, but the standard deviation would be a whole lot more. Using the same formula, it acutally would work out to 7.79.

Applying Standard Deviation to Investing

So how do you apply standard deviation to investing?

Say that you look at the 10-year return of the We Never Lose Growth Stock Fund and find it has returned an average 10% a year over that period. That's fine—but it only tells you half the story. You also want to know how it achieved that 10% average return. Did it return 10% each year over 10 years, or did it return 50% one year and lose 40% the next? You can live with some moderate fluctuation in the average return of an investment from year to year. But you're hardly going to keep cool with an investment that gains 50% one year and loses 40% the next.

Standard deviation tells you how far away from average those returns can swing, over time. The wider the swings—the greater the standard deviation—the more gut wrenching market action you are likely to see. The narrower the swings—the less the standard deviation—the more you have an investment that should let you sleep at night.

Let's look at those two T. Rowe Price funds we looked at when we were talking about beta: Equity Income and Science & Technology: (The data is from Morningstar.)

• Standard deviation for Equity Income is 14.83—meaning that the return might jump around 15% above average one year and might fall around 15% below average another year. That's a relatively modest amount of deviation from the average—not enough to disturb your sleep.

• Standard deviation for Science & Technology is 41.77—meaning the return might jump around 42% below average another year. That's a lot of deviation from the average—not the sort of fund that would help you keep cool.

Standard deviation is widely reported by Morningstar and others that rate mutual funds. It usually is reported by the fund itself. The lower the standard deviation of an individual investment—and of the total of all your investments—the easier it should be to keep cool when the world turns turbulent. It definitely is something to focus on when you build a "keep cool" portfolio against the inevitable fluctuations and deviations you are certain to see in the investment markets.