Portfolio variance is calculated using the standard deviation of each security in the portfolio and the correlation between securities in the portfolio. Modern Portfolio Theory (MPT) states that portfolio variance can be reduced by selecting securities with low or negative correlations in which to invest, like stocks and bonds.
Calculating the Portfolio Variance of Securities
To calculate the portfolio variance of securities in a portfolio, multiply the squared weight of each security by the corresponding variance of the security and add two multiplied by the weighted average of the securities multiplied by the covariance between the securities.
To calculate the variance of a portfolio with two assets, multiply the square of the weighting of the first asset by the variance of the asset and add it to the square of the weight of the second asset multiplied by the variance of the second asset. Next, add the resulting value to two multiplied by the weights of the first and second assets multiplied by the covariance of the two assets.
For example, assume you have a portfolio containing two assets, stock in Company A and stock in Company B. Sixty percent of your portfolio is invested in Company A, while the remaining 40% is invested in Company B. The annual variance of Company A's stock is 20%, while the variance of Company B's stock is 30%.
The correlation between the two assets is 2.04. To calculate the covariance of the assets, multiple the square root of the variance of Company A's stock by the square root of the variance of Company B's stock. The resulting covariance is 0.50.
The resulting portfolio variance is 0.36, or ((0.6)^2 * (0.2) + (0.4)^2 * (0.3) + (2 * 0.6 * 0.4 * 0.5)).
Portfolio Variance and Modern Portfolio Theory
Modern Portfolio Theory is a framework for constructing an investment portfolio. MPT takes as its central premise the idea that rational investors want to maximize returns while also minimizing risk, sometimes measured using volatility. Investors seek what is called an efficient frontier, or the lowest level of risk and volatility at which a target return can be achieved.
Risk is lowered in MPT portfolios by investing in non-correlated assets. Assets that might be risky on their own can actually lower the overall risk of a portfolio by introducing an investment that will rise when other investments fall. This reduced correlation can reduce the variance of a theoretical portfolio. In this sense, an individual investment's return is less important that its overall contribution to the portfolio in terms of risk, return, and diversification.
The level of risk in a portfolio is often measured using standard deviation, which is calculated as the square root of the variance. If data points are far away from the mean, the variance is high, and the overall level of risk in the portfolio is high, as well. Standard deviation is a key measure of risk used by portfolio managers, financial advisors, and institutional investors. Asset managers routinely include standard deviation in their performance reports.