Let's assume that you invest in Company XYZ stock, which has returned an average 10% per year for the last 10 years. How risky is this stock compared to, say, Company ABC stock? To answer this, let's first take a closer look at the year-by-year returns that compose that average:
At first look, we can see that the average return for both stocks over the last 10 years was indeed 10%. But let's look in a different way at how close XYZ's returns in any given year were to the average 10%:
As you can see, only during year 9 did XYZ return the average 10%. In the other years, the return was higher or lower -- sometimes much higher (as in year 7) or much lower (as in year 2). Now look at the annual returns on Company ABC stock, which also had a 10% average return for the last 10 years:
As you can see, Company ABC also averaged 10% return over 10 years but did so with far less variance than Company XYZ. Its returns are more tightly clustered around that 10% average. Thus, we can say that Company XYZ is more volatile than Company ABC stock. Standard deviation seeks to measure this volatility by calculating how "far away" the returns tend to be from the average over time.
For instance, let's calculate the standard deviation for Company XYZ stock. Using the formula above, we first subtract each year's actual return from the average return, then square those differences (that is, multiply each difference by itself):
Next, we add up column D (the total is 3,850). We divide that number by the number of time periods minus one (10-1=9; this is called the "nonbiased" approach and it is important to remember that some calculate standard deviation using all time periods -- 10 in this case rather than 9). Then we take the square root of the result. It looks like this:
Standard deviation = √(3,850/9) = √427.78 = 0.2068
Using the same process, we can calculate that the standard deviation for the less volatile Company ABC stock is a much lower 0.0129.
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