Portfolio variance measures risk by assessing the dispersion of asset returns in a portfolio. Essentially, portfolio variance measures the spread of returns in a portfolio. A portfolio full of assets that have high correlations will have higher portfolio variance.
If you are looking for a way to apply portfolio variance to your investment portfolio, then consider speaking with a financial advisor. They can walk you through the process of applying this concept to your unique situation.
What Is Portfolio Variance?
Portfolio variance is an aggregate of an actual portfolio’s returns for a given period of time. The goal of portfolio variance is to assess the level of risk tied to the portfolio. This is accomplished by using the standard deviation of each security in the portfolio. Additionally, the correlation between securities in the portfolio is taken into account.
Typically, 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 based on a fixed level of risk. When implementing this theory, investors aim to strike a balance between risk and potential returns. Those seeking higher returns need to 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 type of relationship exists between two investments. This 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 seeking to lower 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 to optimize portfolio variance.
Limitations of Portfolio Variance
Portfolio variance offers a helpful way to assess the risks of an overall portfolio. But even after you assess the risks, it might be challenging to make changes based on the portfolio variance 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 diverse portfolio investment is often helpful for investors. But you may want to work with a financial advisor to compare different portfolio strategies.
How to Diversify Your Investment Portfolio
A diverse asset allocation can lower the portfolio variance tied to 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 build an investment portfolio that works best for your individual risk tolerance. Check out our asset allocation calculator if you need help sorting out your options.
- Choose asset classes with low correlation. If you are looking to lower your portfolio’s variance, then investing in assets with low correlation or negative correlation can help you reach that goal. As you make diverse investments, this can help to lower the overall risk attached to your portfolio.
- Monitor your investments over time. As you build your investment portfolio, it’s important to monitor your risk tolerance over time. It’s perfectly natural for your risk tolerance to wane as you age. After all, you’ll likely want to keep those funds more secure if retirement is right around the corner.
Bottom Line
It’s a good idea to measure the level of risk in your portfolio. If you’re looking to lower risk within a portfolio, selecting investments that don’t have any correlation or a negative correlation can lower your portfolio’s variance.
Investment Planning Tips
- You don’t have to run the numbers of portfolio variance on your own. A financial advisor can walk you through the process. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started 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 impact the ideal portfolio.
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