Covariance
Candlefocus EditorThe concept of covariance can be described as the tendency of two variables to move in the same direction, or to diverge from one another. If two variables are positively correlated, they will move together, and have a positive covariance. Variables that diverge from one another have a negative covariance. It is important to note that the relationship between covariance and correlation is not a one-to-one relationship; a correlation coefficient can range from -1 to 1, while a covariance can range from negative infinity to positive infinity.
Covariance is important in modern portfolio theory, as it allows investors to create portfolios that spread out the risk. By finding stocks, bonds, and other investment vehicles that have a negative covariance, investors can pair up assets to reduce risk and volatility in their portfolios. Additionally, when two investments have a positive covariance, they may be used to hedge against losses in one another in the event that one security takes a sudden dive.
In sum, covariance is a powerful tool in portfolio management and other areas of finance. It can be used to balance portfolio risk by pairing investments with a negative covariance, and is a helpful quantitative measure of the relationship between two investments. By considering covariance when constructing portfolios, investors can maximize their chances of gaining a favorable return without exposing themselves to too much risk.