The Hidden Flaw in Standard Deviation: What your Advisor May Not Be Telling You

When it comes to investing, risk is a key factor that affects your returns. But how do you measure risk? And how do you know if your advisor is using the best tools to assess the risk of your portfolio?

One of the most common ways to measure risk in the financial industry is by using standard deviation. Standard deviation is a statistical measure that shows how much the returns of an investment vary from its average over a period of time. The higher the standard deviation, the more volatile the investment is, and the more risk it has.

But did you know that standard deviation can penalize an investment for upside deviation? That’s right! Standard deviation treats both positive and negative deviations from the average equally. This means that an investment that has high returns in some years and low returns in others will have the same standard deviation as an investment that has consistent returns around the average.

Most investors are more concerned about the downside risk, or the possibility of losing money, than the upside potential, or the possibility of making more money. Therefore, standard deviation may not capture the true risk of an investment that has a lot of downside variation.

That’s why there are other tools to measure risk that focus on the downside deviation, or the variation of returns below a certain target or benchmark. For example, one such tool is the Sortino ratio, which measures the excess return per unit of downside deviation. The higher the Sortino ratio, the better the investment is at generating returns while minimizing downside risk.

Another tool is the maximum drawdown, which measures the largest percentage drop in value that an investment has experienced over a period of time. The lower the maximum drawdown, the less severe the losses are, and the less risk the investment has.

These tools can help you better understand the risk of your investments and compare them with other alternatives. However, not all advisors use these tools or explain them to their clients. Some advisors may rely on standard deviation alone, or use other measures that may not suit your risk profile or preferences.

At LaCour Wealth Management, we specialize in providing second opinions to clients who already have a financial advisor. We use a variety of tools and methods to measure and manage risk in your portfolio, and we explain them to you in simple and clear terms.

If you are interested in getting a second opinion on your financial plan and your investments, please contact us today. We would love to hear from you and see how we can help.

In conclusion, while standard deviation is a useful tool for measuring risk, it has some limitations that may not reflect how most rational people view risk. By focusing on the downside deviation, we can get a better understanding of the true risk of an investment. So, next time you’re evaluating an investment, make sure to consider both the upside and downside potential, and use tools like the Sortino ratio to get a more complete picture of the investment’s risk profile. Don’t let the dominant narrative fool you into thinking that standard deviation is the best way to measure risk. Challenge assumptions and take control of your investments today!

This blog post was created with the help of Bing Chat Enterprise, an AI-powered chatbot developed by Microsoft.

The foregoing information has been obtained from sources considered to be reliable, but we do not guarantee that it is accurate or complete, it is not a statement of all available data necessary for making an investment decision, and it does not constitute a recommendation. Any opinions are those of LaCour Wealth Management and not necessarily those of Raymond James.

Raymond James is not affiliated with and does not endorse the opinions or services of Bing Chat Enterprise or Microsoft.