In a perfect world, all investment prices would move steadily in an upward direction with little deviation from that nice, smooth path. In reality, investment prices fluctuate -- sometimes wildly -- with changes in the economy and business environment. While mutual funds are often less volatile than individual stocks, fund prices do vary from day to day and month to month. A fund's standard deviation is one way to measure changes in price over time and can provide valuable information about volatility and risk.
Standard deviation is a measure of volatility -- how far a measurement, such as rate of return, tends to deviate from an average over a particular period. To find standard deviation on a mutual fund, add up the rates of return for the period you want to measure and divide by the total number of rate data points to find the average return. Next, take each individual data point and subtract your average to find the difference between reality and the average. Square each of these numbers and then add them up. Divide the resulting sum by the total number of data points less one -- if you have 12 data points, you divide by 11. The standard deviation is the square root of that number.
The greater the standard deviation, the greater the range in what is being measured. If a fund has an average return of 4 percent and a standard deviation of 7, its past returns have ranged from -3 percent to 10 percent. The same fund with a standard deviation of 2 has a return range of 2 to 6 percent. In investing, high standard deviations typically indicate high volatility -- a return that fluctuates often and by large amounts.
Historical standard deviation is a strong indicator of future performance in a mutual fund. According to Morningstar.com, once a standard deviation is established, future returns will fall within that standard deviation 68 percent of the time; 95 percent of the time, they will fall within two times the standard deviation. You can use standard deviation to compare similar funds. A standard deviation that is significantly different from similar funds may indicate your fund's operations vary in some way -- for better or worse.
The problem with standard deviation is that the number doesn't tell you anything by itself -- and it can be deceptive if not viewed in the proper context. "The Wall Street Journal" reports that low volatility investments, those with low standard deviations, traditionally perform better over time than their peers. However, a fund that consistently loses money will also have a low standard deviation. Review all your mutual fund's statistics and measurements to ensure informed decisions.
Nola Moore is a writer and editor based in Los Angeles, Calif. She has more than 20 years of experience working in and writing about finance and small business. She has a Bachelor of Science in retail merchandising. Her clients include The Motley Fool, Proctor and Gamble and NYSE Euronext.