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Finance allah shmoop what is co variance while co variance

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is a way to tell if two investments will both

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head to millionaire acres together or to the poor house

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together or if one is headed to millionaire acres while

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the other is headed Teo you know the poor house

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three choices there that's where co variance comes in and

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it basically comes in these three flavors Positive co variance

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which means the investments both either grow in value or

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both lose value typically in a linear fashion that's positive

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co variance They're like tied together Negative cove arians means

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that as one investment grows well the other loses like

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loses value also typically in a linear fashion you know

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kind of graphically linear and then you have zero co

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variance which means well we're just sure that whatever their

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relationship is it almost certainly isn't a linear one They're

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just not really varying together They may both grow together

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but in a non linear kind of curvy almost random

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fashion they may head opposite directions but they probably won't

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do it in a straight line of kind of way

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right Well co variances used to help investors make sure

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their portfolios are adequately diversified after all if our when

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one or more markets do crash again it'd be nice

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if our net worth wasn't also completely totally changed right

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Kind of kind of want to hedge your bets there

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a little bit So let's pretend we have a portfolio

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in which all the investments are in companies that make

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different kinds of hand held tech like smartphones and tablets

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and smart watches and you know adult aides of different

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flavors and forms So these investments in our portfolio will

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almost all certainly have a positive co variance with each

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other like they all kind of have the same buyers

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and sellers and appetites and market swings And then the

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surgeon general one day determines that the radiation from handheld

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tech causes monster ism The value of our portfolio will

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hit rock bottom fast stirred on an album of spoken

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word poetry by vladimir putin if instead we had paid

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attention to all that positive co variance data and try

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to get some investments with negative co variance is well

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we might not be looking through the want ads and

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selling plasma every day to pay for food a portfolio

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With a number of pairs of investments with negative co

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variances would mean that while some of our tech stocks

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might have plummetted our monster defense stocks might have skyrocketed

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All right So how do we calculate co variance Well

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they're two ways First we can use the co variance

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formula which has us take one investments returns subtract the

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mean return from each of those returns And repeat that

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for the other investments multiplying all the pairs together to

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sum up those values Wait can we just do this

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step by step All right let's do that that way

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Yeah There we go So let's take the returns from

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two different investments Read from the same time period We'll

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need to find the means The averages of investment one

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and investment to well to get that for investment one

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an average Well we'll add up the returns of five

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point one five point three five hundred francs having and

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if i had a total of twenty seven point two

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by five giving us an average there Five point four

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for for investment too We had three point three of

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your own and these are like percent returns on bonds

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Or something like that That's A kind of think about

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a total seventeen point nine five by five and we

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get three point five eight Right now we subtract the

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mean from each individual return So for investment one that

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means subtracting the mean of five point four four from

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each data point you get five point one five point

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three five point four five seven five seven Not to

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be mean But that means we also need to subtract

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the mean of investment to which was that three point

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five eight from each of those data points and so

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on And get what we mean here that's How it

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should look so next up multiply the matched pairs of

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points like negative zero point three four times negative zero

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point two eight and then negative point one four times

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Negative point one eight and so on All right time

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to some All those values to get point o nine

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five two plus point two five two plus uh negative

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went for a a aa plus Pulling on three One

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two and five seven two gives us point two oh

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four There we go What We finish up dividing that

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Some by one last the number of hairs of data

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points So we'll divide by point two Oh four There

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that thing will divide that by four Which gives us

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a cove Arians finally of point Oh five one What

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the hell does that mean Well that positive cove arians

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means that in general as investment one gains value in

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general so too does investment to or that in general

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as investment one loses value so too does investment to

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meaning they're pretty correlated So it's not a huge issue

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to have some investments with positive co variances but the

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entire portfolio i probably shouldn't be made up of positive

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cove Arians pairs of investments maybe kick in a few

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investments to the curb in favor of some that produced

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negative co variances Good idea no matter how attached you

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are to a particular investment or sector of the economy

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Well now that we've used the actual co variance formula

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what are other ways we can do A ploy to

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find co variance Well we can calculate the correlation coefficient

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a k a the r value r r squared value

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of the data points And then multiply that value by

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both the standard deviation of the ecs data and the

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standard deviation of the wide data Okay well the individual

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standard deviations and our values can be quickly calculated using

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technology like a graphing calculator website er's frenchie or something

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like that using a graphing calculator on those same returns

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from investments one into from before while we found our

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to be point nine o two one exit standard deviation

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to be point two six eight and wise standard deviation

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be point two one six eights is just different Pairs

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of investments Like a bond portfolio How correlated worthy Well

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when we multiply point nine o two one by point

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two six away and then by point two one six

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eight we get a co variance love wait for it

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point oh five one yeah we've seen that number before

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And we're not in the matrix Alright again a positive

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cove Arians means that the two investments will probably either

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both grow in value over same time period or probably

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lose value together over the same time period They may

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grow or lose value of different race but whatever direction

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one goes in well the other follows Think about him

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Like penguins were kind of you know sniffing each other

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well A negative co variance will mean that is one

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investment gains value than the everyone loses value and that's

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Good Sometimes people call that ej that's kind of a

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good thing to have stabilized Report Follow at least in

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the short term a well diversified portfolio should have enough

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pairs of investments or combinations of investments that have negative

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co variances so that they protect you in the really

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ugly scenarios Right now we just have to figure out

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who's going to clean up the office before the boss 00:06:41.797 --> [endTime] gets back

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