Standard Deviation in Mutual Funds: Meaning, Formula and Importance

Standard deviation can be defined as a statistical measure expressed as a percentage that indicates the level to which returns of a mutual fund can deviate from its mean annual returns. It is an effective way of measuring the degree of risk and volatility of a mutual fund scheme. This statistical indicator considers past performance and tells investors the degree of deviation in actual returns versus expected returns from the investment.

In simple words, we can say that if the standard deviation of a mutual fund scheme is high, it implies that returns generated from such funds may be significantly higher or lower than its average return. Suppose the standard deviation of a mutual fund comes out to 3%, and the average annual return of the same is 15%. In such a scenario, the expected returns could be in the range of 12-18%.

Now that we have understood the definition of standard deviation with respect to mutual funds, let’s take a close look at the standard deviation calculation formula.

The formula to calculate the standard deviation in mutual funds is given below:

Standard Deviation = {((∑ (A - B )²)/(n-1)}^1/2

• A stands for returns generated during a particular time frame
• B stands for mean annual returns
• n stands for the total number of years i.e. investment period

Here is a step-by-step guide on how to derive standard deviation in mutual funds:

 Step 1: Record the annual returns for each year i.e. A

 Step 2: Compute the average annual return of the mutual fund i.e. B

 Step 3: Subtract the mean annual return from the returns of each year. This will give deviation from the mean i.e., (A-B)

 Step 4: Square the deviations of every year.

 Step 5: Add the squared deviations of every year.

 Step 6: Divide this summation by (n-1) years to get the variance

 Step 7: Square root the variance value to get the standard deviation of the mutual fund.

Standard deviation in a mutual fund allows market participants to know the range of deviation from the average annual returns over a time period. Let’s take the standard deviation which we have computed in the previous section i.e., 8 (rounded off for calculation convenience). The average annual return stands at 20%.

Therefore, investors can get an idea that the future returns from this particular mutual fund may deviate by 8% on the higher side to become 28% or deviate by 8% on the lower side to become 12%. Standard deviation helps investors by giving a range of future returns.

Here are some pointers that reflect the importance of standard deviation in mutual funds:

•  Measures risk: Standard deviation is valuable for investors as it measures the total risk rather than just the market-triggered volatility. Hence, it is a more comprehensive statistical metric than other parameters


•  Future performance indicator: The standard deviation is an important marker of future returns generated from a mutual fund. Investors can comprehend and estimate returns in an objective manner. This will help them in sound financial planning and decision-making.


•  Universality: One can use the standard deviation in all types of mutual funds, whether they are debt funds , equity funds, or hybrid funds . The universality principle makes it easier to use.


•  Comparison: Standard deviation in mutual funds helps investors in comparison to similar mutual funds. One can use it to compare the average returns of the same category of funds.

The benefits discussed in the above points provide an answer to the most pressing question of how SD can help in selecting the mutual funds to invest in .

Although standard deviations promise a lot of benefits to their users but at the same time, it also suffers from certain drawbacks. A quick go-through of the limitations shall help the investors with effective analysis and informed decision-making. Some limitations of standard deviations in mutual funds are as follows:

•  Narrowness: The standard deviation only measures the risk based on historical data. Therefore, in order to have a comprehensive viewpoint of the volatility associated with a particular mutual fund, one has to compare the standard deviation with other fund-related data like alpha, beta, Sharpe Ratio, Sortino, etc.


•  Not useful for multiple funds: Standard deviation is used to find out the risks associated with individual mutual funds. If an individual has investments in multiple mutual funds, standard deviation needs to calculated for individual funds separately to find out the volatility of the entire portfolio. This can be a tedious task if the number of funds in the portfolio is large.


•  Provides an estimated range: Many experts have argued that standard deviations provide an estimated range of future returns. However, in many cases, it has been found that the deviation is higher or lower than the given range. This is because, in the case of market-linked investments, historic returns do not guarantee future performance of the scheme.

A higher standard deviation means that there is a higher degree of variation from the average returns. It helps investors get an idea about the data spread, but it is in no way an indicator of how a fund is performing. Investors should avoid investing in a specific fund by looking at only the standard deviation variable.