Arnel L.

Cadeliña Lecture and Assignment 3 on Standard Deviation-

Behavioral Finance January 8, 2017

ASSIGNMENT NO. 3 (50 points)

Direction:

1) Read the Lecture below and practice

2) Compute and graph using Excel your 1 stock from PSEi and 1 stock from a Philippine
mutual fund based on the example below. Only for 5 years return but USE ACTUAL 5
YEARS RETURN.

3) Conclude which is the most volatile and risky.

4) Due January 17 for MW and January 18 for TTH

5) Non-compliance of directions means zero points.

Standard Deviation
What it is:
Standard deviation is a measure of how much an investment's returns can vary from its average
return. It is a measure of volatility and in turn, risk. The formula for standard deviation is:

Standard Deviation = [1/n * (ri - rave)2]½

where:
ri = actual rate of return

rave = average rate of return

n = number of time periods

For math-oriented readers, standard deviation is the square root of the variance.

How it works (Example):

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:
 Arnel L. Cadeliña Lecture and Assignment 3 on Standard Deviation-
Behavioral Finance January 8, 2017

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%:
 Arnel L. Cadeliña Lecture and Assignment 3 on Standard Deviation-
Behavioral Finance January 8, 2017

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):
 Arnel L. Cadeliña Lecture and Assignment 3 on Standard Deviation-
Behavioral Finance January 8, 2017

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.