How reliable is standard deviation in gauging a fund’s volatility?

Most investors have the tendency to look at past returns before investing in a mutual fund. Schemes with high returns in the past appear attractive. But past returns have no bearing on future returns. Worse, schemes that have done well in the past may perform poorly as well. That underlines the need for setting expectations right. Is there a better way to examine past returns?

Gauging volatility

One way to check your scheme’s worth is to measure how volatile it has been in the past. Gauge your scheme’s standard deviation (SD). SD is a statistical measure of volatility caused by a variety of factors that are in your fund manager’s control (stock or sector selection) or those beyond her ambit (macro economy). You will get to know your scheme’s SD from its factsheet every month or on from third party fund rating websites.

In simple terms, a high standard deviation typically means that your fund is quite volatile.

For example, assume that you have two schemes to choose from for investing your hard-earned money. Both schemes deliver 12 per cent returns. However, scheme A has a SD of 20 and scheme B has a SD of 5. So, scheme A is more volatile than scheme B.

Ideally, for a conservative investor, scheme B makes sense as it is less volatile, other things remaining the same. However, you must consider these schemes in the light of your risk appetite and financial goals. You should consult your financial advisor before taking investment decisions, if required.

Using standard deviation

These numbers (returns and SD) are the outcome of actions taken by the fund manager in the past. If you change the time period under observation, the numbers would be different. Understand how a scheme’s SD has changed over a period of time, as fund managers can change the composition of their portfolios.

“Though standard deviation gives an idea about volatility to investors, they should not rely too much on it to choose schemes for investments, given its limitations,” says Ravi Kumar TV, founder of Gaining Ground Investment Services. Qualitative factors such as portfolio construction, investment process also influence expected returns from a scheme, he adds.