Standard Deviation

Standard Deviation (often used interchangeably with volatility) is a statistical measure that tells you how much a set of data, like a stock's historical returns, tends to vary or spread out from its mean (or average). Think of it as a financial rollercoaster rating. A low standard deviation is like a gentle kiddie ride; the ups and downs are small and predictable, clustering tightly around the average experience. A high standard deviation is like a terrifying, triple-looping beast of a coaster; the highs are exhilarating, and the drops are stomach-churning, with massive swings far from the average. In the world of investing, a higher standard deviation signals greater price swings and is traditionally seen by academia as a proxy for higher risk. For a value investor, however, the story is a bit more nuanced.

You don't need a PhD in mathematics to grasp the concept. While the formula looks intimidating, the idea is straightforward. Imagine you're looking at a stock's monthly returns for the past year. To find the standard deviation, you would:

1. 1. Calculate the average monthly return for that year.
2. 2. For each month, measure how far the actual return was from this average. Some months will be above, some below.
3. 3. Square each of these differences. This clever step makes all the differences positive (so they don't cancel each other out) and gives more weight to the bigger swings.
4. 4. Average all those squared differences. This result has a special name: variance.
5. 5. Take the square root of the variance. This brings the number back into a normal percentage, giving you the standard deviation.

This final number represents the “typical” amount a stock's return is likely to stray from its average in any given period.

Let's make this real. Consider two fictional companies:

• Steady Eddie Utilities: This company provides electricity and has very predictable earnings. Its stock has an average annual return of 6% with a standard deviation of 8%. This means in a typical year, its return will likely be somewhere between -2% (6% - 8%) and +14% (6% + 8%). It's a relatively smooth ride.
• Wild Ride Tech: This is a cutting-edge software company with blockbuster hits and major flops. It boasts an average annual return of 15%, but with a massive standard deviation of 30%. In a typical year, its return could be anywhere from -15% (15% - 30%) to +45% (15% + 30%). The potential rewards are higher, but so is the heart-stopping volatility.

Academic finance, particularly Modern Portfolio Theory (MPT), would label Wild Ride Tech as far “riskier” than Steady Eddie Utilities based solely on this number.

Here’s where we, as value investors, take a different path. While standard deviation is a useful tool for understanding an asset's price behavior, we believe it is a deeply flawed measure of true investment risk.

MPT and its followers make a critical mistake: they equate volatility with risk. To them, a stock price that bounces around wildly is, by definition, risky. This perspective completely ignores the underlying business. Is a wonderful business that you bought for 50 cents on the dollar “riskier” just because its price temporarily drops to 40 cents? Of course not. The business is the same; only the price tag has changed. The real risk isn't the fluctuation of the price but the potential for a permanent loss of your invested capital.

Legendary investors like Benjamin Graham and Warren Buffett have taught us that volatility is not the enemy of the intelligent investor; it is their greatest friend. We see risk not as a twitchy stock price but as paying too much for a business, irrespective of how “stable” its stock chart looks. The wild price swings of a company—its high standard deviation—are often driven by the manic-depressive mood swings of what Graham called Mr. Market. When Mr. Market is in a panic and offers you a fantastic business at a foolishly low price, that high volatility is your opportunity, not your risk. The true risk of permanent capital loss comes from buying a mediocre business at a high price, even if its stock price has been stable for years. For a value investor, a high standard deviation in a fundamentally sound, well-understood company is simply a dinner bell, signaling that it might be time to buy.