Standard Deviation

• It was first used by Karl Pearson in the year 1893.

• Standard Deviation is the square root of the arithmetic average of the squares of the
deviations measured from the mean.

• Standard deviation is also known as root mean square deviation.

• The standard deviation is denoted by Greek letter σ

• It is a measure of how spread out a data set it. It’s used in a huge number of applications. In
finance, standard deviations of price data are frequently used as a measure of volatility. In
opinion polling, standard deviations are a key part of calculating margins of errors.

The following examples explain how the standard deviation is used in real life scenarios.

1. Standard deviation in weather forecasting.

A weatherman who works in a city with a small standard deviation in temperatures year-round can
confidently predict what the weather will be on a given day since temperatures don’t vary much from
day to the next.

2. Standard deviation in health care

Insurance analysts often calculate the standard deviation of the age of the individuals they provide
insurance for so they can understand how much variation exists among the age of individuals they
provide insurance for.

3. Standard deviation in real estate

Real estate agents calculate the standard deviation of the house prices in a particular area so they can
inform their clients of the type of variation in the house prices they can expect.

4. Standard deviation in human resource

HR managers often calculate the standard deviation of salaries in a certain field so that they can know
what type of variation in salaries to offer to new employees.

5. Standard deviation in marketing

Marketers often calculate the standard deviation of the number of ads used by competitors to
understand whether or not competitors are using more or less ads than normal during given period.

6. Standard deviation in test scores

Professors can calculate the standard deviation of test scores on a final exam to better understand
whether most students score close to the average or if there is a wide spread in test score.

7. Standard deviation in finance

Within the field of finance, we can use standard deviation to determine the volatility [variability] of
returns from investments in various asset classes including

• Stocks – including both dividends and capital appreciation

• Bonds – including corporate and municipal

• Commodities – such as gold and silver

For example, let’s say we have the chance to invest in two different stocks

The stocks have the following historical performance over 10 years

I. Stock A: mean annual return = 7%, standard deviation of annual returns = 7%

II. Stock B: mean annual return = 7%, standard deviation of annual returns = 2%

Both stocks have same average rate of return, but the variability is much higher for stock A. The stock
you choose to invest in will depend on your tolerance for volatility of returns.

If you are fine with the possibility of negative returns in exchange for a good chance at double digit
return then you would choose to invest in stock A

If you would like to preserve your capital and avoid negative returns, then you would choose to invest in
stock B.

Note: if you wish to get an average return of 7% with a standard deviation between 2% and 7%, you
could buy some shares in both stock A and B to balance your portfolio.

There are many other applications too.

The luck factor in a casino is qualified using standard deviation. The standard deviation of a simple game
like roulette can be simply calculated because of the binomial distribution of successes [ assuming a
result of 1 unit for a win and 0 unit for a lose].

The standard deviation for the even-money. Roulette bet is one of the lowest out of all casino’s games.
Most games, particularly slots have extremely high standard deviations. As the size of the potential
payouts increase, so does the standard deviation.

Key points

• Standard deviations can assist in determining the target price of a security.

• It does not identify the trend or direction but reveals the price movement based on the
historical data.

• Sometimes it may provide misleading information, due to unexpected developments regarding

the company.

• Standard deviation in coordination with other indicators is more useful than focusing on it as the
sole indicator.

• It is unlikely to contribute majorly in intra-day strategies or day trading sessions.