Definition
Portfolio variance is a measure used in finance to assess the total risk or volatility of a portfolio of investments. It is calculated by determining the standard deviation of returns from the expected returns of all individual investments within the portfolio, and their respective weights. It shows the dispersion of the combined asset returns, suggesting how much they could deviate from the expected combined return.
Key Takeaways
- Portfolio Variance is a measure of the dispersion of returns of a portfolio. It is the total risk in holding a portfolio of multiple investments, expressed as the total standard deviation for the portfolio.
- It is used in portfolio management to help diversify and optimize a portfolio by analyzing how the individual securities in the portfolio interact with each other and how they contribute to the portfolio’s overall risk. This helps in constructing a portfolio that maximizes returns for a given level of risk.
- Calculating Portfolio Variance takes into account the variances in returns of the individual assets and their correlations. It relies on the principle that the variance of the sum of different variables is the sum of their variances and correlations.
Importance
Portfolio variance is a fundamental concept in finance and investing because it provides a quantitative measure of how the returns of assets within a portfolio move together over time. It’s a critical aspect of risk management, helping investors understand the degree of risk or uncertainty associated with their investments.
The importance of portfolio variance lies in its role in diversification. If the returns of the assets in a portfolio are perfectly positively correlated, the portfolio’s overall risk is the same as the risk of any one of the assets.
However, if the assets’ returns are not perfectly correlated, the portfolio’s overall risk can be lower than the risk of the individual assets, demonstrating the benefit of diversification. Hence, portfolio variance is used in determining the optimal portfolio that will generate the best returns for a given level of risk.
Explanation
Portfolio variance is an essential tool used to measure the dispersion of returns of a portfolio. It serves to quantify the degree of risk or volatility a particular portfolio holds. When the portfolio variance is high, it indicates that the investment portfolio has significant variability in its expected returns which could spell potential risk.
Conversely, a lower variance implies more stability, demonstrating that the returns from the portfolio are less likely to deviate from the expected values. Investors primarily use portfolio variance to optimize their portfolio. It informs them about the volatility amongst the various assets and how different securities move in relation to each other.
By understanding the variation in returns, they can adjust their investments and diversification strategy accordingly to mitigate risk. It’s particularly helpful for investors who aim to accomplish a stable and predictable profit stream. So, the main purpose of calculating portfolio variance is to manage and control the investment risk, allowing investors to make more informed and strategically advantageous decisions.
Examples of Portfolio Variance
Retirement Savings: An individual planning for retirement might have a portfolio containing a mix of stocks, bonds, and other assets. The portfolio variance here would be the measure of how the return on these investment assets varies. For example, if a significant percentage of the portfolio is in high-risk stocks, the portfolio variance will be high. If the individual wants less volatility, they may shift some of their assets into less risky investments like government bonds, which would decrease the portfolio variance.
Investment in Technology Sector: Suppose an investor has invested solely in technology stocks like Google, Amazon, and Apple. The portfolio variance in this context will measure the degree of risk associated with this investment strategy. If any one stock, say Apple, experiences a significant decrease in price, the high portfolio variance would reflect the high risk of volatility in returns.
Mutual Funds: Mutual fund managers use the concept of portfolio variance to design diversified portfolios that can optimize returns and minimize risks for their investors. For instance, a fund manager may have a portfolio comprising of auto sector stocks, pharmaceutical companies, and real estate stocks. If any one sector, such as the auto sector is likely to underperform, this will impact the portfolio’s return and increase its variance. To minimize this risk, the fund manager may decide to reallocate funds into other sectors with better performance outlooks, thus managing the portfolio variance.
FAQs on Portfolio Variance
Q1: What is Portfolio Variance?
Portfolio Variance is a measure of the dispersion of returns of a portfolio. It is the total risk of the portfolio, which is a combination of systemic risk and unsystemic risk. In finance, the riskier the portfolio, the higher the portfolio variance.
Q2: How is Portfolio Variance calculated?
Portfolio variance is calculated by multiplying the squared weight of each security by its corresponding variance and adding two multiplied by the weighted average of the securities of the portfolio times the covariance of the each security pair in the portfolio.
Q3: What is the importance of Portfolio Variance in finance?
Portfolio variance is a vital concept in finance as it provides an idea about the total risk of the portfolio. It helps in determining the level of risk an investor is bearing and it can be used to compare the risk assumed to the expected returns.
Q4: What should be done if the Portfolio Variance is too high?
If the portfolio variance is too high, it signifies that the risk of the portfolio is high. The investor should consider diversifying their investments more or re-evaluating their investment strategy to lower the risk level. Remember, a successful investment requires balancing the risk and return.
Related Entrepreneurship Terms
- Risk Diversification: An investment strategy to spread risk across many investments or asset classes.
- Covariance: A statistical measure that indicates the extent to which two securities’ returns move together.
- Standard Deviation: A statistical measurement that helps to gauge the historical volatility of a stock’s price.
- Correlation Coefficient: A measure that determines the degree to which two securities’ movements are related.
- Expected Return: An estimate of the potential return on an investment or a portfolio.
Sources for More Information
- Investopedia: An amazing resource for financial topics with easy-to-understand information, focusing on making complex financial information accessible to everyone.
- Corporate Finance Institute: A professional educational institute, that provides online training and certification for finance professionals.
- Khan Academy: A free online educational platform focusing on a wide range of subjects, including finance.
- The Balance: A personal finance website with lots of guides and articles about investing, retirement planning, and more.
