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What Is the Connection between Standard Deviation and Risk?

Terry Masters
Terry Masters

Standard deviation is a statistic that investors use to measure the risk associated with a particular stock or investment portfolio. Deviation in an investment's returns from the average rate of return over time demonstrates its volatility. The interplay between standard deviation and risk reveals more volatile investments that are considered riskier. Their returns may fluctuate too wildly and prevent investors from developing confidence that the investment will pay a specific return at any particular time.

An individual's investment strategy is typically based on his tolerance for risk. The notion of risk encompasses the possibility or likelihood that the investor could lose all or part of the money he invested. Investments that are viewed as risky have a higher probability of failing, but often also offer higher returns to compensate for the higher risk. Analysts are always looking for reliable ways to determine risk, so they can structure their client's portfolio to meet their tolerance level.

Woman holding a book
Woman holding a book

Out of the various ways of evaluating investments, standard deviation and risk are viewed as being the most reliably collated. Standard deviation measures how far an investment's returns deviate from its average rate of return. The average rate is determined by adding up an investment's returns over a time period and dividing the result by the number of data points. Once the average is determined, an analyst can use that point to determine how widely the investment's returns fluctuate.

Investments that provide slow and steady growth are considered safer because investors can more reliably anticipate what their investment will be worth if they have to liquidate it at some point in the future. It might seem relevant to evaluate an investment's increase in value over time, or the range of its returns, but that only shows growth and does not reveal volatility. Standard deviation and risk share a connection that reveals how likely it is for the investment to have a much different value at any point in time as a comparable point.

The connection between standard deviation and risk enables analysts to design investment strategies to meet the needs of their clients. For example, a young professional with few responsibilities may be able to gamble on a riskier investment strategy in the hopes of a higher rate of return from his portfolio. Likewise, an elderly investor may want safe and steady returns on his investments. By using standard deviation, an analyst can properly craft an investment strategy that has a reliable risk correlation for each client.

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