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IAI Actuarial Core Principles · Economic Modelling · Measures of investment risk

Which is a recognised limitation of using standard deviation as the sole measure of investment risk?

A key limitation is that standard deviation treats gains and losses symmetrically, so it fails to capture downside risk and can mislead when returns are skewed or heavy-tailed. Measures such as semi-variance, shortfall probability or value at risk address this weakness.

  1. AIt cannot be calculated for normally distributed returns
  2. BIt ignores the investor's mean return entirely in its calculation, making it always zero
  3. CIt does not distinguish downside losses from upside gains and may mislead for skewed returnsCorrect
  4. DIt always overstates risk for portfolios with negative correlations
  5. It requires the returns to be perfectly correlated with the market

Explanation

Standard deviation is symmetric, so for skewed distributions or investors who care only about shortfall it can misrepresent risk. This motivates downside measures such as semi-variance and shortfall probability. The other statements are false.

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