Expected return and standard deviation are important factors in investment decisions. Expected return is the average return over a period of time, while standard deviation measures the extent to which returns differ from the expected return. The higher the standard deviation, the lower the probability of achieving the expected return. Investors must consider risk tolerance when choosing between high returns and high risk.
Expected return and standard deviation are connected in the world of finance because a high standard deviation will decrease the probability that the investor will actually receive the expected return. The expected return is measured as an average of the returns over a period of years. In contrast, the standard deviation shows the extent to which the returns differed from the expected return over that same period of time. Investors must take expected return and standard deviation into account when deciding on their security selections, as they have to choose whether to earn high returns if the risk associated with those returns is correspondingly high.
Using the term expected return in the stock market is a bit of a misnomer, since stock prices are fickle at best and downright unpredictable at worst. Certain investors might be looking for consistency over a period of time. Others may wish to make large profits at the expense of exposure to a particularly volatile stock. Risk tolerance is crucial to how investors view the connection between expected return and standard deviation.
It is important to understand what is meant by expected return and standard deviation before their relationship can be explored. The expected return of a stock is what the return should be based on the returns of previous years. Rather, the standard deviation is a measure of how much that stock has deviated from the expected return over time. As the standard deviation increases, so does the chance that the stock will not match the expected return.
To show how expected return and standard deviation are linked, consider the example of two stocks that have been around for three years and each have an expected return of 15 percent. The A shares returned 14 percent, 15 percent, and 16 percent over the three years, while the B shares returned 10 percent, 15 percent, and 20 percent over the same three years. While the average return for both was 15 percent, stock B deviated from that return much more than stock A.
From that example, it can be said that stock B is much less likely to achieve its expected return based on past performance. If an investor wants an expected return reaching 15 percent with little risk, they should choose Stock A. Conversely, an investor with a higher risk tolerance might choose Stock A and hope the time is right for a Big deviation in a positive direction. The amount of risk an investor wishes to incur is the ultimate determinant of how he or she views the relative importance of expected return and standard deviation.
Smart Asset.
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