Examining Portfolio Risk: Understanding Variance and Covariance
Calculating portfolio risk is one of the vital aspects of investing. Along with gauging portfolio performance, it’s equally important for you to carry out portfolio risk analysis to understand the quantum of risk in your portfolio. Variance and covariance are among the several tools you can use to calculate portfolio risk. Here’s how.
What Is Variance?
Variance reflects how much the returns of an asset fluctuate over time. A high degree of variance indicates higher risk, while a lower variance suggests less risk. Let's understand this with an example. Suppose you have two stocks in your portfolio: A and B.
Over the past year, the price of stock A fluctuated between ₹90 and ₹110. On the other hand, the price of stock B moved between ₹80 and ₹120. As you can see, stock B has a wider range than stock A. This means it has a higher variance than stock A, and hence, it is riskier than stock A.
What Is Covariance?
Covariance reflects the relationship between the returns of two assets in a portfolio. It shows whether they move in similar directions or opposite directions. Covariance could be positive or negative. When covariance is positive, it shows that both assets are moving in the same direction. On the other hand, when covariance is negative, it shows both assets move in opposite directions. Let's understand it with an example.
Suppose your portfolio has stocks of two companies — company A and company B. If both stock prices increase when markets and the economy are doing well, they have a positive covariance. On the other hand, if the stock price of company A rises in a booming economy while that of B comes down, it means they have a negative covariance.
Using Variance And Covariance For Portfolio Optimisation
You can use variance and covariance for portfolio optimisation and mitigating risk. Let’s see how. Suppose you want to invest in two stocks — tech and utility. The tech stock has a high variance, while the utility stock has a low variance. This means that tech stock is riskier than utility stock as it fluctuates more. If you combine and invest in both of them, their combination could reduce the overall risk.
Also, if both these stocks have a negative covariance, it can further balance risk. This is because, due to negative covariance, the tech stock may fall while the utility stock may rise, thus balancing your risk. The table captures key differences between variance and covariance on various aspects:
| Aspects | Variance | Covariance |
|---|---|---|
Measures | Degree of fluctuation in returns of a single asset | Relationship between returns of two assets |
Value interpretation | Higher the variance, higher the risk and vice versa | Positive covariance is an indication of assets moving in the same direction, while negative covariance means movement in opposite direction |
Effect on portfolio | Showcases the impact of total risk of holding an individual asset | Impacts diversification effect when combining two assets |
In conclusion
A holistic view of portfolio risk can help you proactively protect your portfolio from market vagaries. It can help you make more informed decisions to navigate market volatility and earn stable returns in the long run.
Disclaimer: This article is for informational purposes only and does not constitute financial advice. It is not produced by the desk of the Kotak Securities Research Team, nor is it a report published by the Kotak Securities Research Team. The information presented is compiled from several secondary sources available on the internet and may change over time. Investors should conduct their research and consult with financial professionals before making any investment decisions. Read the full disclaimer here.
Investments in the securities market are subject to market risks, read all the related documents carefully before investing. Please read the SEBI-prescribed Combined Risk Disclosure Document before investing. Brokerage will not exceed SEBI’s prescribed limit.
