Standard Deviation: How to Efficiently Assess Risk in Investments

When entering the world of investing, it's natural to be concerned about risk. After all, no one wants to see their hard-earned money decrease in value. This is where standard deviation comes into play—a fundamental concept in finance for measuring the risk of an investment or portfolio.

Standard deviation is a statistical measure that indicates how much the values in a data set deviate from the mean. In simple terms, it tells us how volatile or unpredictable an investment might be. The higher the standard deviation, the greater the variation in returns, and consequently, the higher the risk.

Why is this important? Suppose you're choosing between two investments: the first has an average annual return of 8% with a standard deviation of 2%, while the second also has an average return of 8% but with a standard deviation of 5%. Despite having the same average return, the second investment is riskier because its returns vary more around the mean.

To build a more diversified and potentially more profitable portfolio, it's crucial to consider standard deviation. By combining investments with different standard deviations, you can reduce the overall risk of your portfolio while maintaining a good potential for return. An important point to note is that when calculating the standard deviation of a portfolio, you must consider not only the standard deviation of each individual asset but also the correlation between them.

Correlation between two financial assets is a statistical measure that indicates how the prices of these assets move relative to each other. By choosing assets with negative or low correlations, investors can reduce the overall risk of the portfolio because the movements of one asset can offset the movements of another.

It is important to highlight that, although standard deviation is a valuable tool in risk analysis, it should not be the sole factor considered. In the next article, we will discuss how, in extreme cases, constructing a portfolio based solely on the mean of standard deviations and their correlations may not yield the expected results. Other important factors to consider include drawdown, Sharpe ratio, Sortino ratio, among others, which are also crucial for effective diversification.

To assist with this complex task, working with an investment advisor can be a great option. An advisor can analyze your risk profile, financial goals, and help you build a diversified portfolio tailored to your needs.

In summary, understanding standard deviation is essential for anyone looking to invest safely and efficiently. By using it as a risk metric, you'll be better prepared to build a solid portfolio and achieve your financial objectives.

‍