Portfolio Variance
Candlefocus EditorBy taking the weights and variances of each asset in the portfolio, along with their correlating covariances, into account, the portfolio variance gives a more complete assessment of a portfolio’s risk. This is especially useful when comparing portfolios that have different numbers of assets and different correlations.
When two securities have low correlation, the portfolio variance will be lower. This is because there is less chance of high and low returns canceling each other out, reducing overall risk. Low correlation between securities is desirable for diversification, and a lower portfolio variance indicates that the portfolio offers a separate source of return from the broader market, which can reduce overall portfolio risk.
Modern portfolio theory (MPT) postulates that portfolio variance, along with standard deviation, define the risk axis of the efficient frontier. The efficient frontier is a graph that compares the expected returns with expected levels of risk for a given portfolio. By plotting portfolio variance and standard deviation on the efficient frontier, investors and advisors can compare the risk and return of potential portfolios.
In short, portfolio variance is a measure of overall portfolio risk and is calculated by taking into account the weight, variances, and covariances of each asset. It is a useful tool that can be used to measure the correlation between securities in a portfolio, and subsequently, to measure a portfolio’s risk on the efficient frontier.