What is portfolio variation?
Portfolio variance is a process that identifies the degree of risk or volatility associated with an investment portfolio. The basic formula for calculating this variance focuses on the relationship between what is known as the variance of return and the covariance that is associated with each of the securities found in the portfolio, along with the percentage or part of the portfolio it represents. . The idea behind portfolio variance is to determine whether the current mix of assets found in the portfolio is generating a favorable overall return, in addition to evaluating the performance of each security contained in the portfolio.
To understand how portfolio variance is calculated, it is necessary to define what is meant by covariance and return variance. Covariance is the relationship that exists between two random variables; In the case of evaluating the performance of a portfolio, it refers to the relationship between two of the assets that are held in the portfolio. Yield variance looks at the rate of return of a security compared to another security in the portfolio. By considering these two elements, it becomes easier to identify how each of the securities works to increase the value of the portfolio, or how specific assets actually inhibit the portfolio growth process.
Taking the time to identify the portfolio rate of change that is present in any given portfolio is important for two reasons. First, the process can help the investor achieve balance of assets within the portfolio. This is essential if the investor wants to minimize the impact of a recession within a given market on the portfolio. By maintaining this balance, it is possible for commodity and bond issues to help offset the losses that occur when stocks traded in a given market experience some sort of temporary decline.
The second benefit to determining portfolio variance has to do with assessing how well current assets are helping the investor achieve his financial goals. If progress towards these targets does not occur at the rate originally projected, the process can help the investor develop a plan to review the portfolio structure. The plan may involve selling some assets and acquiring others, or retaining all current assets, adding new investments to the mix. Improving portfolio variance can also involve activities such as altering portfolio content so that non-equity investments share a higher percentage or proportion of the overall portfolio value.