Mean & Standard Deviation

Analyzing Investment Returns

The arithmetic mean and standard deviation are the first and most simple of the basic statistical concepts
used in investing. The mean and standard deviation of returns provide the basic profile of any security with
respect to risk and return.

The mean, in statistics, is merely the arithmetic average. For example, if you have average returns for 10
years, you simply add them together and divide by 10 to find the mean. (See the general form of the
calculation and an example below.) The term "mean" usually refers to the arithmetic mean but there's also
ageometric mean, which will be discussed in the section on comparing mutual funds with key
statistics ("Compare Funds" on the menu bar).

The mean is used as an estimate of expected future returns of mutual funds because it's the best estimate
we can make solely from past data. Analysts have many resources at their disposal to help them project the
future returns of securities and they have the time required to put those resources to work. However, most
of us don't have the time and resources to do detailed securities analysis and, as the focus of this site is
mutual fund investing, it's really not relevant to us. For all intents and purposes, predicting future mutual
fund performance from historical data is appropriate as long as any trends are noted and taken into
consideration. So we use the mean to project the future and always deliver the obligatory caveat that past
returns are not necessarily indicative of future returns.

The standard deviation is a measure of variability which is used as the standard measure of the total risk
of individual assets and portfolios of assets. There are two variants of standard deviation: population and
sample. The sample standard deviation is used when working with historical returns, as they are deemed to
be samples unless 100% of the data points are used in the calculation. The population standard deviation is
only used when working with 100% of the data points. Daily NAVs from a fund's inception through the most
recent trading day would be considered to be a population. Monthly returns for the past ten years is a
sample.

In plain English, the standard deviation is the absolute value of the average deviation of the data points
from the mean. In mathematical terms the it is the square root of the sample variance and the sample
variance is the sum of the squared deviations divided by the number of data points less one, (n - 1). To
compute the population variance, you would simply divide by n instead of (n - 1) and the population
standard deviation would be the square root of the population variance.

The arithmetic mean return is computed as follows:

rAvg = [Sum(ri)]÷ n

Where:
n= the number of data points and i = 1 through n.
When rAvg is used as an estimate of future returns it is
referred to as the expected value of r, E(r).

The population standard deviation is computed as follows:

Population Variance = V = [Sum(ri- rAvg)2] ÷ n
Population Standard Deviation = S = V1/2

Where V1/2 is equivalent to the square root of V.

The sample standard deviation is computed as follows:
Sample Variance = V = [Sum(ri- rAvg)2] ÷ (n - 1)
Sample Standard Deviation = S = V1/2

Where V1/2 is equivalent to the square root of V.

Here's an example calculation for a sample:

In the Interest Rates subsection I introduced the risk-free rate of return, r*, as being the basis from which
securities are priced. As the T-Bill rate is used as a proxy for r*, the basis can vary quite a bit over time.
Indeed, the T-Bill rate was above 17% in 1981 and as low as 0.01% in 2009. Therefore, the proper way to
evaluate returns is with excess returns, which is the actual return less the average T-Bill rate for the
period over which the returns were computed. In the example above, the period was yearly, so the average
T-Bill rate for each year should have been deducted from each year's return. However, you won't find this in
most published data, so you should do it yourself. (Historic T-Bill rates can be found on the U.S. Treasury's
web site.) If the T-Bill rate was relatively stable over the period being analyzed, then it's not terribly
important, as you'll be comparing everything on a relative basis. But if you compare raw returns for 2009 to
1981, you'll not be comparing apples to apples. If your only means of projecting future returns is by using
historic returns, then you definitely should work with excess returns.

Security returns have been found to be approximately normally distributed, which means it's relatively safe
to use the normal distribution to make some general inferences of what can be expected if the past is
repeated in the future. This is a pretty good assumption for the variability of returns but not the returns
themselves. But, as mentioned above, that's all most of us have so that's what we use, thus the standard
disclaimer that past returns are not necessarily indicative of future returns.

Standard Deviation Rules of Thumb

Here are some rules of thumb regarding the standard normal distribution. (The probabilities have been
rounded, as these are just rules of thumb.): 68% of the probability lies within one standard deviation of the
mean, and as the distribution is symmetric, that 68% can be interpreted as being centered on the mean.
What's that mean, you say? It means that the actual return for any given year could have been expected to
be within one standard deviation of the mean 68% of the time. In the example above, there's a 68%
probability that the return in any year selected at random from the 10-year sample would be between
-10.5% (13.4 - 23.9) and +37.3% (13.4 + 23.9). As the distribution is symmetric, this can be refined to a
34% probability that the return would be between 13.4% and -10.5% and a 34% probability that it would
be between 13.4% and 37.3%. But that only covers 68% of the probability.

There's nearly a 96% probability that the return for any given year was within two standard deviations of
the mean and nearly a 100% probability that it was within three. Again, this is centered on the mean, so it
can be interpreted as +/- 2 SD and +/- 3 SD respectively.

Standard Deviation Rules of Thumb

Span Probability

+/- 1 SD 68%

+/- 2 SD 96%

+/- 3 SD 100%

The mean splits the total probability of normally distributed data. Thus there is a 50% probability that the
return for any year would be less than the mean and a 50% probability that it would be greater than the
mean. Taking this a step farther, we can look at the upside and downside potential on a cumulative basis.
This is shown in the following table and charts:

Cumulative Probabilities of the Standard Normal Distribution

Number of
Standard
Deviations -4 -3 -2 -1 0 +1 +2 +3 +4
from the
Mean, X

Probability
of being X
Standard
>0.49999 0.4987 0.4772 0.3413 - 0.3413 0.4772 0.4987 >0.49999
Deviations
from the
Mean

Cumulative
Probability,
<0.00001 0.0013 0.0228 0.1587 0.50000 0.8413 0.9772 0.9987 <0.99999
Left to
Right

Cumulative
Probability,
>0.99999 0.9987 0.9972 0.8413 0.50000 0.1587 0.0228 0.0013 <0.00001
Right to
Left

The first row of probabilities are the probabilities that the actual return will be X standard deviations (SD)
from the mean. For example, there is a 34.13% probability that the return will be between the mean and
one SD greater than the mean. Also, the probability of being between -1 SD and +1 SD is 68.26%.

The second row of probabilities is the pessimistic view. This tells us that there is a 2.28% probability that
the return will be greater than two SD below the mean and a 15.87% probability that it will be greater than
one SD below the mean. In the example above, these would be losses of 34.4% and 10.5%, respectively.

The third row of probabilities is the optimistic view. This tells us that there is a 97.72% probability that the
return will be greater than two SD below the mean and an 84.13% probability that it will be greater than
one SD below the mean.
This is how risk is viewed in the world of investing and why understanding standard deviation is so
important. If you can assemble a portfolio that has a standard deviation equal to its expected return you will
only have a 16% probability of losing money in any one year, (100% - 84% = 16%).

In the example above, there is a 34% probability that a portfolio comprised solely of the large-cap growth
fund could lose as much as 10.5% in any year based on annual return data from 1997 through 2006. More
specifically, using the probability tables for the standard normal distribution, there is a 12.9% probability
that the portfolio's return will be between 0.0% and -10.5% and a 15.9% probability that a loss greater
than 10.5% will be suffered, and the total probability of a loss is 12.9% + 15.9% = 28.8%. Diversifying that
portfolio would reduce its standard deviation. Good diversification can be achieved by assembling a portfolio
whose constituent securities have a low degree of correlation with each other, which is the topic of the next
subsection.

Return to the top of Mean & Standard Deviation.

Return to the Investing Basics summary page.

Move on to the next subsection, Correlation. http://www.investing-in-mutual-funds.com/standard-

deviation.html