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the investment deviate from the average return during specific periods of time. Higher risk investments carry a wider range of short-term outcomes but also carry higher expected returns, compensating investors for withstanding short-term volatility. In contrast, investments that have had a narrow range of outcomes over long periods of time are expected to provide more consistent returns with the trade-off of lower returns. For example, an all-bond index portfolio has provided a small but consistent return, while an all-equity index portfolio has provided a larger but more erratic return. Higher expected returns are the reward for an investor’s willingness to accept this volatility. In other words, risk is the source of returns and, therefore, should be embraced in appropriate doses.

Standard Deviation Of Returns An effective and common method to measure the deviation of investment returns from the average is the standard deviation of returns. Standard deviation provides a statistical measure of historical volatility and sets forth a distribution of the ranges of probable outcomes. In investing, measuring standard deviation of returns shows the extent to which returns (daily, monthly or annual) are distributed around the average return, estimating a range of probable outcomes and establishing a likely framework of risk and return trade-offs. The normal distribution in the form of a bell-shaped curve shown in Figure 8-1 illustrates the concept of standard deviation. The curve represents a set of outcomes. In this case, let’s say the outcomes are the monthly returns of an investment.

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