Standard Deviation

sigma

definition

It is usually denoted with the letter σ (lower case sigma). It is defined as the square root of the variance. To understand standard deviation, keep in mind that variance is the average of the squared differences between data points and the mean. Variance is tabulated in units squared. Standard deviation, being the square root of that quantity, therefore measures the spread of data about the mean, measured in the same units as the data.

For example, in the population {4, 8}, the mean is 6 and the deviations from mean are {−2, 2}. Those deviations squared are {4, 4} the average of which (the variance) is 4. Therefore, the standard deviation is 2. In this case 100% of the values in the population are at one standard deviation of the mean.

The standard deviation is the most common measure of statistical dispersion, measuring how widely spread the values in a data set are. If many data points are close to the mean, then the standard deviation is small; if many data points are far from the mean, then the standard deviation is large. If all the data values are equal, then the standard deviation is zero.

Dark blue is less than one standard deviation from the mean. For the normal distribution, this accounts for about 68% of the set (dark blue) while two standard deviations from the mean (medium and dark blue) account for about 95% and three standard deviations (light, medium, and dark blue) account for about 99.7%.

of financial investments

standard deviation is one measure of risk

correlates the expected return with the various returns over time.

The less the variation, the lower the risk.

The higher the standard deviation, the higher the risk

See also : the "Normal Distribution"

the standard deviation is the usual way to discuss the spread of a normal distribution.

Is an important "bell-shaped' curve. Symmetric about its mean.

• 68% within one
• 95% within two
• 99% within three

six sigma is a statistical reduction of errors down to 99.9997 , or below 3.4 defects per (one) million opportunities, which was pioneered by Motorola

More about finance & standard deviation

In finance, standard deviation is a representation of the risk associated with a given security (stock, bond, property, etc.), or the risk of a portfolio of securities. Risk is an important factor in determining how to efficiently manage a portfolio of investments because it determines the variation in return on the asset and/or portfolio and gives investors a mathematical basis for investment decisions. The overall concept of risk is that as it increases, the expected return on the asset will increase as a result of the risk premium earned - in other words, investors should expect a higher return on an investment when said investment carries a higher level of risk.

For example, you have a choice between two stocks: Stock A historically returns 5% with a standard deviation of 10%, while Stock B returns 6% and carries a standard deviation of 20%. On the basis of risk and return, an investor may decide that Stock A is the better choice, because the additional percentage point of return (an additional 20% in dollar terms) generated by Stock B is not worth double the degree of risk associated with Stock A. Stock B is likely to fall short of the initial investment more often than Stock A under the same circumstances, and will return only one percentage point more on average. In this example, Stock A has the potential to earn 10% more than the expected return, but is equally likely to earn 10% less than the expected return.

Calculating the average return (or arithmetic mean) of a security over a given number of periods will generate an expected return on the asset. For each period, subtracting the expected return from the actual return results in the variance. Square the variance in each period to find the effect of the result on the overall risk of the asset. The larger the variance in a period, the greater risk the security carries. Taking the average of the squared variances results in the measurement of overall units of risk associated with the asset. Finding the square root of this variance will result in the standard deviation of the investment tool in question. Use this measurement, combined with the average return on the security, as a basis for comparing securities.

Formula:

square root of the variance

More links

Wikipedia article about standard deviation

risk

return

Finance