Show pageOld revisionsBacklinksBack to top This page is read only. You can view the source, but not change it. Ask your administrator if you think this is wrong. ======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. ===== The Nitty-Gritty: How It's Calculated (Conceptually) ===== 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. Calculate the average monthly return for that year. - 2. For each month, measure how far the actual return was from this average. Some months will be above, some below. - 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. Average all those squared differences. This result has a special name: [[variance]]. - 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. ===== Standard Deviation in Practice: A Tale of Two Stocks ===== 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. ===== The Value Investor's Perspective on Standard Deviation ===== 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. ==== The Problem with Modern Portfolio Theory's View ==== 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. ==== Volatility as Opportunity ==== 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.