What is Standard Deviation
What is Standard Deviation?
Standard deviation is a calculation and terminology that provided me with my first reinforcement into studying finance. ‘Standard deviation is equal to the square root of the variance’, when I read this note I wrote in my text book, it still does not make any sense to me. This is why interpretation is so important and when studying numbers it can be all about the facts, so we need a balance, standard deviation can be considered a balance.
Standard deviation is a way to calculate the fluctuating range of an assets return, for example a stock. A straight path could potentially be ploughed through the winding snow in the image above, but more needs to be considered. Suppose that over 5 years the snow fall in a particular area was 12 meters (year 1) 17 meters (year 2) 8 meters (year 3) 11 meters (year 4) and 22 meters (year 5). Placed into columns below;
Year 1 - 12
Year 2 - 17
Year 3 - 8
Year 4 - 11
Year 5 - 22
We have the data for the snowfall, now we work out the average, which we do by adding up all of the snowfall numbers and dividing by the amount of data points (5 years). 12+17+8+11+22 = 70 then divide by 5 = 14. Our average snowfall over the last 5 years is 14 meters, but how likely is this to fluctuate and what is the possibility range? Standard deviation answers this.
How to calculate Standard Deviation
Microsoft Excel is your best friend when it comes to learning about finance as the formula’s within the program eliminate time consuming calculations. In a blank excel cell type =STDEV.S( and start filling in the data 12,17,8,11,22) hit enter = 5.52 is the Standard deviation.
To apply the deviation we add the SD (Standard deviation) figure to the average (14) to work out the high end and minus the SD from the average to work out the low end.
Average 14 + 5.52 = 19.52 high end
Average 14 - 5.52 = 8.48 low end
Completing this process provides you with the ability to calculate roughly 2 thirds (66.7%) of the actual forecasted snowfall. To bring this back to a stock purchase, based on the same data the share return is likely be within the range of 19.52% to 8.48%.
