Understanding Mutual Fund Volatility: A Comprehensive Guide

There are a number of statistical analytical products that can provide insight into a mutual fund's volatility, or relative risk on the market. The more volatile a fund is, the less able you are to predict returns. Returns could be very high leading up to the year you purchase the fund, then drop substantially the following year. A less volatile stock will present consistent returns over time. Financial advisers use common measures to analyze volatility, but you may quickly become confused if you do not know what the measures mean.

Standard Deviation

The standard deviation of a mutual fund is a measure of how different returns are across a period of time. Standard deviation means the same thing in any application. For example, in a family where the children are all very close in age, the standard deviation of the age of a child will be low. In a family where the children are spread out across many years, the standard deviation would be high. The standard deviation of a mutual fund is no more complicated than this explanation even though the formula for determining a deviation is complex. Thankfully, you can find the standard deviation of any mutual fund in most listings, so you do not have to do the calculation yourself.

Beta

A fund's beta is another common measure of volatility. The beta compares a fund's performance to a benchmark. Beta is another measure that is complex to actually calculate, but not complex to understand. Simply put, the closer a mutual fund's beta is to one, the less volatile the stock is. If the beta is greater than one, the stock is more volatile; bond's with a beta less than one are less volatile than the benchmark. A common benchmark could the the S&P 500, which is a stock index that can be used to estimate the total performance of the market. If your mutual fund has a beta of one when compared to the S&P, the you are operating at a similar volatility to the market as a whole.

Efficient Frontier

Ultimately, these calculations and a few others can be used to determine not only how volatile a stock is but whether it is worth the risk. This is often expressed in what is called the efficiency frontier. The frontier is a curve, similar to the supply and demand curve, that represents an optimal output for each input. On a scale of one to ten, for example, you may purchase a mutual fund that has a risk of three. The return, then, would also be three to make the risk worthwhile. If your fund is performing above the efficient frontier and earning back four for a risk of three, you are exceeding market expectations. This is a very simple expression of the efficient frontier, but it is these simple expressions that make the options easier to understand. Along the frontier, there are several stops you can make. If you do not feel the additional risk that would be required to gain more profits is worthwhile to you, then it is best to stop where you are.