Yesterday, I wrote about beta, a measure of systematic risk (risk which can not be avoided). Today, I am going to add unsystematic risk to the equation and cover a measure of total risk: the historical standard deviation.
Unsystematic risk is often referred to as firm-specific risk or diversifiable risk because it can be reduced by adding stocks to a portfolio.
The standard deviation measures how the actual returns of a stock vary from the stock’s expected rate of return.
Unlike a beta of 1.0, there is no benchmark level for the market’s standard deviation, but a higher standard deviation indicates higher variability of returns (more risk).
Stocks with higher standard deviations should have higher expected rates of return.
In theory, 99.7 percent of the actual observations should fall within plus or minus three standard deviations of the mean.
In plain English, three standard deviations below the mean would reflect “what’s the worst that could happen” and three standard deviations above the mean reflects “what’s the best that could happen.”
Unfortunately, just like beta, the historical standard deviation is based on history. Many investors use what has happened in the past to form expectations of what will happen in the future, but nothing is guaranteed.
BTW – If you would like to find the standard deviation of the returns of your stocks, leave a comment and I will e-mail you the instructions for retrieving data from Yahoo! Finance and exporting it to Excel.