Critically discuss the use of standard deviation as a risk indicator for investment purposes - Essay Example

A greater standard deviation implies a greater volatility. More the volatility, more the risk. Generally, high risk is associated with high returns and high losses. Therefore, a fund with higher average returns and lower volatility is the most preferred option. However, such an ideal situation rarely materializes and the investors have to strike a balance between returns and risk due to volatility. Standard deviation acts as a useful tool in achieving this balance. Standard deviation is not a failsafe method for risk measurement.

Standard deviation has an inherent limitation that it is based on analysis of past data. That is why it is also known as historical volatility. The allocation of assets in a stock or fund in the past may be entirely different from the situation today. Therefore, past performance would not be a suitable indicator of future performance. In this case several external factors would have to be considered and standard deviation may fail to give desired results. Standard deviation does not give information about the current debt structure of the company.

It does not take into account the recent changes. For example, a certain company may have an average debt of 30% of the total capital structure over the past 20 years but suddenly over the past year the company has taken a large amount of debt which has take it to 60%. This would have an impact on the financial condition of the company and stockholders are bound to suffer. However, a standard deviation would still show a decent amount of volatility in accordance with previous debt structure. This leads us to the interpretation that standard deviation alone should never be used as a risk indicator.

Many analysts believe that standard deviation is a measure of volatility and not of risk. This has to do with the fact that risk means different things for different people. For some investors, risk implies losing all of their investment, for others a negative return