Measuring Portfolio Performance Variability

B

Standard deviation is also a useful measure of the relative volatility of fund categories.

The correct answer is B. standard deviation.

In the context of portfolio performance, the standard deviation is a measure of the variability or dispersion of the historical returns around their central tendency or mean return. It quantifies the degree to which the returns deviate from the average return.

Here's a more detailed explanation:

Standard deviation is a statistical measure that calculates how much the individual data points in a set deviate from the mean (average) of that set. It provides a measure of the dispersion or variability of the data points. In the case of portfolio performance, the historical returns of the portfolio are the data points.

The first step in calculating the standard deviation is to determine the mean return of the portfolio, which represents the central tendency or average return. This is done by summing up all the historical returns of the portfolio and dividing by the number of observations.

Next, each individual return is subtracted from the mean return, creating a set of deviations. These deviations can be positive or negative, depending on whether the return is above or below the mean.

To calculate the standard deviation, the deviations are squared to eliminate any negative values and then averaged. This step is necessary to ensure that all the deviations contribute equally to the final result. Taking the square root of the average of the squared deviations gives the standard deviation.

The standard deviation represents the average amount by which each individual return deviates from the mean return. It is expressed in the same units as the returns themselves, such as a percentage. A higher standard deviation indicates greater variability or dispersion of returns, suggesting higher risk or volatility in the portfolio. On the other hand, a lower standard deviation implies less variability and lower risk.

Therefore, in the context of portfolio performance, the standard deviation is used as a measure of risk. Investors and portfolio managers often use it to assess the volatility or variability of a portfolio's historical returns. A higher standard deviation implies a wider range of potential outcomes, increasing the uncertainty associated with the portfolio's future performance.