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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 return variance and the covariance that is associated with each of the securities found in the portfolio, along with what percentage or portion of the portfolio that each security represents. The idea behind portfolio variance is to determine if the current combination of assets found in the portfolio are generating a favorable return overall, while also assessing the performance of each security contained within the portfolio.
In order 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 assessing the performance of a portfolio, this refers to the relationship between any two of the assets held in the portfolio. Return variance looks at the rate of return of a security in comparison with another security within the portfolio. By considering both these elements, it becomes easier to identify how each of the securities are working to enhance the value of the portfolio, or how specific assets are actually inhibiting the growth process for the portfolio.
Taking the time to identify the rate of portfolio variance that is present in any given portfolio is important for two reasons. First, the process can aid the investor in managing to maintain a balance of assets within the portfolio itself. This is essential if the investor is to minimize the impact of a downturn within a certain market on the portfolio. By maintaining that balance, it is possible for commodities and bond issues to help offset any losses that take place when stocks traded on a given market go through some type of temporary slump.
The second benefit to determining portfolio variance has to do with assessing how well the current assets are helping the investor reach his or her financial goals. In the event that progress toward those goals is not proceeding at the pace originally projected, the process can help the investor develop a plan to overhaul the structure of the portfolio. The plan may involve selling some assets while acquiring others, or holding on to all current assets while adding new investments to the mix. Enhancing portfolio variance may also involve activities like shifting the contents of the portfolio so that investments other than shares of stock compose a higher percentage or proportion of the overall value of the portfolio.
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