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2
(R
B
) are variances and
Cov(R
A
, R
B
) is the covariance
Example: Portfolio Variance
Data on both variance and covariance may be displayed in a covariance matrix. Assume the
following covariance matrix for our two-asset case:
Stock Bond
Stock 350 80
Bond 150
From this matrix, we know that the variance on stocks is 350 (the covariance of any asset to
itself equals its variance), the variance on bonds is 150 and the covariance between stocks
and bonds is 80. Given our portfolio weights of 0.5 for both stocks and bonds, we have all
the terms needed to solve for portfolio variance.
Portfolio variance = w
2
A
*
2
(R
A
) + w
2
B
*
2
(R
B
) + 2*(w
A
)*(w
B
)*Cov(R
A
, R
B
) =(0.5)
2
*(350) +
(0.5)
2
*(150) + 2*(0.5)*(0.5)*(80) = 87.5 + 37.5 + 40 = 165.
Standard Deviation
Standard deviation can be defined in two ways:
1. A measure of the dispersion of a set of data from its mean. The more spread apart the
data, the higher the deviation. Standard deviation is calculated as the square root of
variance.
2. In finance, standard deviation is applied to the annual rate of return of an investment to
measure the investment's volatility. Standard deviation is also known as historical volatility
and is used by investors as a gauge for the amount of expected volatility.
Standard deviation is a statistical measurement that sheds light on historical volatility. For
example, a volatile stock will have a high standard deviation while a stable blue chip stock
will have a lower standard deviation. A large dispersion tells us how much the fund's return
is deviating from the expected normal returns.
Example: Standard Deviation
Standard deviation () is found by taking the square root of variance:
(165)
1/2
= 12.85%.
We used a two-asset portfolio to illustrate this principle, but most portfolios contain far
more than two assets. The formula for variance becomes more complicated for multi-asset
portfolios. All terms in a covariance matrix need to be added to the calculation.
Let's look at a second example that puts the concepts of variance and standard deviation
together.
Example: Variance and Standard Deviation of an Investment
Given the following data for Newco's stock, calculate the stock's variance and standard
deviation. The expected return based on the data is 14%.
Scenario Probability Return Expected Return
Worst Case 10% 10% 0.01
Base Case 80% 14% 0.112
Best Case 10% 18% 0.018
Answer:
2
= (0.10)(0.10 - 0.14)
2
+ (0.80)(0.14 - 0.14)
2
+ (0.10)(0.18 - 0.14)
2
= 0.0003
The variance for Newco's stock is 0.0003.
Given that the standard deviation of Newco's stock is simply the square root of the variance,
the standard deviation is 0.0179, or 1.79%.
(For further reading, see Investing Myths That Need To Go and 5 Reasons You Should Love
Stocks.)