Risk
Standard deviation
A statistical measure of how far values typically sit from their average.
How it works
Applied to returns it gives volatility. Roughly two-thirds of observations fall within one standard deviation of the mean and about 95% within two, if returns are normally distributed.
That last condition is the catch. Market returns have fatter tails than a normal distribution, so extreme moves happen far more often than the maths predicts.
Where it misleads people
A "five standard deviation event" should occur roughly once in several thousand years. Markets produce them every few years, which tells you the model is wrong rather than that something impossible happened.
Related terms
- VolatilityHow much an investment’s returns bounce around their average — the standard measure of risk.
- Fat tailsThe tendency of extreme market moves to happen far more often than standard statistics predict.
- Value at riskAn estimate of the most you would expect to lose over a period, at a stated confidence level.
- Normal distributionThe symmetric bell-shaped curve that much of finance assumes returns follow.
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