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Standard deviation

How To Use Standard Deviation and CAGR in Mutual Funds?

Understanding the role of standard deviation (STD) in mutual fund investment can be quite beneficial for an investor. Often, people are not aware of the term ‘std full form’ or how it can impact their investment portfolio.

Let’s start by understanding its full form. The STD full form stands for Standard Deviation. It is a statistical term that measures the level of variability or dispersion around an average. When applied to mutual fund investment, it helps to quantify the volatility or risk involved.

So, how does it work in mutual funds? Basically, a higher standard deviation implies greater volatility, while a lower standard deviation suggests a more stable return expected from a mutual fund scheme. Therefore, it can be an important tool to gauge the risk in a fund’s returns. In mutual funds, STD is measured over periods such as a 1-year, 3-year period, and so on.

Now, the question arises as to how is the standard deviation calculated. It can be calculated in three steps:

Step 1: Calculation of Mean: The first step is to calculate the mean or average return of the mutual fund scheme. For instance, if you invested in mutual fund XYZ that gave returns of 10%, 12%, and 8% over three years. The mean is calculated by (10+12+8)/3=10%.

Step 2: Calculation of Variance: The second step involves calculating variance, which is the average of squared differences from the Mean. Here, you square the difference between each return and the average. In our example, it is: ((10%-10%)^2+(12%-10%)^2+(8%-10%)^2)/3 = 1.33%.

Step 3: Calculate Standard Deviation: The third and final step is easy. You simply take the square root of variance, i.e., √1.33% = 1.15%. Hence, the standard deviation of mutual fund XYZ is 1.15%.

While the STD provides valuable insights, it’s important to use it in conjunction with other indicators. It is also necessary to understand that high STD does not necessarily imply bad investment as the fund might be targeting higher returns.

What is CAGR?

What is CAGR? The Compound Annual Growth Rate (CAGR) is a useful measure to understand the mean annual growth rate of an investment over a specified period longer than one year. Unlike a simple average, CAGR provides a smoothed annual rate that describes how an investment grows from its beginning balance to its ending balance if it has grown at a steady rate. This metric is particularly valuable for comparing the growth rates of different investments or financial products.

CAGR is widely used in finance and business to compare the historical performance of investments, forecast the future growth, and set performance targets. It smooths out the volatility inherent in year-to-year growth rates, making it easier to understand the long-term growth potential and stability of an investment. Understanding “What is CAGR” can help investors make more informed decisions and set realistic expectations for their investment returns.

Benefits on CAGR

The Compound Annual Growth Rate (CAGR) offers several key benefits, making it a valuable tool for investors and businesses. Here are some of its main advantages:

  1. Simplicity and Clarity:
  • CAGR provides a single, easy-to-understand growth rate that summarizes the performance of an investment over a period of time, eliminating the complexity of analyzing year-by-year growth rates.
  1. Comparability:
  • It allows for the straightforward comparison of the growth rates of different investments or financial products, even if they have different time horizons. This helps in making informed investment choices.
  1. Smoothing Volatility:
  • CAGR smooths out the effects of volatility and short-term fluctuations in the investment’s performance, offering a clearer picture of long-term trends.
  1. Realistic Projections:
  • By assuming steady growth, CAGR provides a more realistic projection of future returns compared to simple averages, which might be skewed by extreme values.

Disclaimer

This article is for informational purposes only and not a recommendation for any specific mutual fund investment. Investments in mutual funds are subject to market risks, hence it’s recommended that investors should take their own decision after assessing all the pros and cons of trading in the Indian financial market. It’s also advisable to consult with a financial advisor for a better understanding of investment risks and return