Portfolio variance measures risk by assessing the dispersion of asset returns in a portfolio. Essentially, portfolio variance measures the distribution of returns in a portfolio. A portfolio full of assets that have high correlations will have higher portfolio variance.
If you’re looking for a way to apply portfolio variance to your investment portfolio, consider talking to a financial advisor. They can guide you through the process of applying this concept to your unique situation.
What is portfolio variance?
Portfolio variance is an aggregate of the actual returns of a portfolio for a given period of time. The purpose of the portfolio variance is to gauge the level of risk associated with the portfolio. This is accomplished by using the standard deviation of each security in the portfolio. In addition, the correlation between the securities in the portfolio is taken into account.
Generally, a high portfolio variance indicates a higher level of risk. On the other hand, a lower portfolio variance indicates a lower level of risk.
Portfolio Variance and Modern Portfolio Theory
Modern Portfolio Theory (MPT) is a strategy that focuses on maximizing returns given a fixed level of risk. When implementing this theory, investors aim to strike a balance between risk and potential returns. Those looking for higher returns must be comfortable taking on more risk. But those with a lower risk tolerance should expect lower returns on their investments.
According to MPT, you can manipulate portfolio variance based on your investment choices. In other words, you can reduce variance by choosing investments that have minimal correlations.
Correlation indicates what kind of relationship exists between two investments. It can be a positive or negative relationship. For example, two investments that move in tandem have a positive relationship. But two investments that move independently of each other are negatively correlated.
When looking to reduce portfolio variance, many investors choose to invest in both stocks and bonds. Due to the consequences of portfolio variance, many decide to diversify their investment portfolio. Ultimately, a diverse selection of investments can help optimize portfolio variance.
Portfolio Variance Limits
Portfolio variance provides a useful way to assess the risks of an overall portfolio. But even after assessing the risks, it can be difficult to make changes based on the variance of the portfolio itself.
Instead, you’ll need to take a broader look at your investment portfolio and financial goals to make the appropriate adjustments to your portfolio. A diversified portfolio investment is often useful for investors. But you might want to work with a financial advisor to compare different portfolio strategies.
How to diversify your investment portfolio
A diversified asset allocation can reduce the portfolio variance associated with your investments. Here are three common ways to diversify your investments:
Explore your ideal risk tolerance. Everyone has a different comfort level when it comes to investing. The good news is that there is no right or wrong level of risk tolerance. Instead, you’ll simply need to create an investment portfolio that best suits your individual risk tolerance. Check out our Asset Allocation Calculator if you need help sorting out your options.
Choose low correlation asset classes. If you are looking to reduce the variance in your portfolio, investing in low correlation or negative correlation assets can help you achieve this goal. As you make diversified investments, this can help reduce the overall risk in your portfolio.
Track your investments over time. As you build your investment portfolio, it’s important to monitor your risk tolerance over time. It is perfectly natural that your tolerance for risk decreases as you age. After all, you’ll probably want to better protect those funds if retirement is just around the corner.
It’s a good idea to measure the risk level of your portfolio. If you are looking to reduce risk within a portfolio, selecting investments that have no correlation or a negative correlation can reduce your portfolio variance.
Investment Planning Tips
You don’t have to calculate the portfolio variance figures yourself. A financial advisor can guide you through the process. SmartAsset’s free tool connects you with up to three financial advisors who serve your area, and you can interview your matching advisors for free to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, start now.
Determining the right balance of assets for your level of risk tolerance can be tricky. Explore SmartAsset’s free asset allocation calculator to see how different risk tolerance levels affect the ideal portfolio.
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