Do Mutual Funds Understate their Volatility?

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It is probably fair to say that the standard deviation, as a measure of total risk, fell out of favor when researchers discovered that diversification makes only systematic risk relevant to investors. Since even small portfolios of 12 to 18 stocks can eliminate as much as 90 percent of a portfolio's unsystematic risk (Evans and Archer, 1968), it is reasonable to think that average and institutional investors alike attach little importance to their holdings' standard deviation. Why then should it matter if mutual funds understate their standard deviations? After all, even grossly understated standard deviations can still overstate the risk of well-diversified funds.

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