Standard deviation

Standard deviation is still the most widely used measure of dispersion, or in financial markets, risk.

It is based on the idea that any population is ‘normally distributed’ meaning that no matter whether it contains say the height of every UK adult male or the annual return from the FTSE 100 over 100 years, most members of the group will be bunched around the arithmetic average for the whole group (for heights, that’s the sum of every individual’s height divided by the number of males in the UK).So a randomly chosen UK adult will be on average close to say 5’9″ – with only a few people significantly above or below that ‘mean’ height – so-called ‘outliers’.

Standard deviation quantifies the average dispersion of, say, heights or equity returns, above or below the mean figure. The higher the standard deviation, the greater the risk that a randomly chosen adult is nowhere near your expected 5’9″, or the return from equities next year is way above or below the past 100-year average.

Merryn

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