Investment analysis and portfolio management 2023

Chapter Four
Portfolio analysis and selection

4.1 Conceptualizing portfolio

Portfolio refers to a collection of investment tools such as stocks, shares, mutual funds, bonds, and
cash and so on depending on the investor’s income, budget and convenient time frame.

 Portfolio: set of diversified investments.

 It works with principle of diversification.
 Helps to reduce Unsystematic risks.
 It doesn’t affect systematic risks.

4.2 Portfolio Management

The art of selecting the right investment policy for the individuals in terms of minimum risk
and maximum return is called portfolio management. Portfolio management refers to managing
an individual’s investments in the form of bonds, shares, cash, mutual funds etc so that he/she earns
the maximum profits within the stipulated time frame and acceptable level of risk. Portfolio
management also refers to managing money of an individual under the expert guidance of portfolio
managers.

4.2.1 Need for Portfolio Management

 Portfolio management presents the best investment plan to the individuals as per their
income, budget and ability to undertake risks.
 Portfolio management minimizes the risks involved in investing and also increases the
chance of making profits.
 Portfolio managers understand the client’s financial needs and suggest the best and unique
investment policy for them with minimum risks involved.
 Portfolio management enables the portfolio managers to provide customized investment
solutions to clients as per their needs and requirements.

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4.2.2 Types of Portfolio Management

Portfolio Management can be classified in to the following types:

1. Active Vs passive portfolio management

 Active Portfolio Management: As the name suggests, in an active portfolio management

service, the portfolio managers are actively involved in buying and selling of securities to
ensure maximum profits to individuals.
 Passive Portfolio Management: In a passive portfolio management, the portfolio manager
deals with a fixed portfolio designed to match the current market scenario.

2. Discretionary Vs Non- discretionary

 Discretionary Portfolio management services: In Discretionary portfolio management

services, an individual authorizes a portfolio manager to take care of his financial needs on his
behalf. The individual issues money to the portfolio manager who in turn takes care of all his
investment needs, paper work, documentation, filing and so on. In discretionary portfolio
management, the portfolio manager has full rights to take decisions on his client’s behalf.
 Non-Discretionary Portfolio management services: In non-discretionary portfolio
management services, the portfolio manager can merely advise the client what is good and
bad for him but the client reserves full right to take his own decisions.

4.2.3 The Key Elements of Portfolio Management

 Asset Allocation: The key to effective portfolio management is the long-term mix of assets. Asset
allocation is based on the understanding that different types of assets do not move smoothly, and
some are more volatile than others. Asset allocation seeks to optimize the risk/return profile of
an investor by investing in a mix of assets that have low correlation to each other. Investors with
a more aggressive profile can weight their portfolio toward more volatile investments. Investors
with a more conservative profile can weight their portfolio toward more stable investments.

 Diversification: The only certainty in investing is, it is impossible to consistently predict the
winners and losers, so the prudent approach is to create a basket of investments that provide
broad exposure within an asset class. Diversification is the spreading of risk and reward within
an asset class. Because it is difficult to know which particular subset of an asset class or sector is
likely to outperform another, diversification seeks to capture the returns of all of the sectors over
time but with less volatility at any one time. Proper diversification takes place across different
classes of securities, sectors of the economy and geographical regions.

 Rebalancing: it is a method used to return a portfolio to its original target allocation at annual
intervals. It is important for retaining the asset mix that best reflects an investor’s risk/return

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profile. Otherwise, the movements of the markets could expose the portfolio to greater risk or
reduced return opportunities. For example, a portfolio that starts out with a 70% equity and 30%
fixed-income allocation could, through an extended market rally, shift to an 80/20 allocation that
exposes the portfolio to more risk than the investor can tolerate. Rebalancing almost always
entails the sale of high-priced/low-value securities and the redeployment of the proceeds into
low-priced/high-value or out-of-favor securities. The annual iteration of rebalancing enables
investors to capture gains and expand the opportunity for growth in high potential sectors while
keeping the portfolio aligned with the investor’s risk/return profile.

Portfolio management is the process of matching the return and risk characteristics of an
investor’s portfolio with his or her desired financial objectives. While scientific and technical in
nature, there is also an art to the portfolio management process.

Objective and Constraint Identification

Most investors enjoy selecting investments and are inclined to jump to this step right away, but
defining financial goals always comes first. Knowing the endgame—investing for financial freedom in
retirement, building and protecting wealth, funding education or other goals—sets up the rest of the
process. Before deciding where to invest, a risk questionnaire is useful to further define an investor’s
risk and return objectives and constraints on the investment process. Since investors typically
choose portfolios with either too much or too little risk, match goals with investment choices is
critical.

Capital Market Expectations

After defining goals and analyzing risk tolerance, capital market expectations (CMEs) are made.
Created from scratch or taken from a third-party source, such as Ibbotson, CMEs are the expected
return and risk for different asset classes. They are used in the mathematical analysis of how to
allocate assets in a portfolio, based on an investor’s pre-specified goals.

Implementation

Asset allocation is based on goals for return and risk as well as constraints, such as liquidity/cash
flow needs, time horizon, tax and other unique circumstances. Once these are reviewed,
implementation can begin. Based on how asset classes affect each other and the overall return and
risk profile for the portfolio, a number of different asset classes are specified by the advisor, along
with a targeted allocation range for each. While the portfolio is a collection of individual investments,
a majority of portfolio variability is determined by asset allocation. This makes asset allocation a
critical component in the portfolio management process.

An essential concept in asset allocation is the correlation among investments and asset classes.
Correlation is a measure of how related two things are, with 1 meaning perfectly correlated and -1

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being perfectly negatively correlated. With investments, if one stock always goes up 1 percent and
another always goes down 1 percent, they have a perfect negative correlation of -1. By having
investments that perform differently, the overall risk level (as measured by volatility) in the portfolio
can be greatly reduced. By adding different investments with low correlation, the overall risk in the
portfolio is reduced. This is why diversifying into international investments and other assets classes,
which both derive return from different factors than domestic stocks, is so important in portfolio
management.

Another important consideration is human capital, which is the present value of an investor’s future
labor income. Although it cannot be traded, it may be the largest asset that anyone has and should be
treated like any other asset class. To hedge against human capital risk, life insurance is an important
consideration. Typically, human capital needs are higher earlier in life and, therefore, more life
insurance should be used to offset the potential loss, especially for those with dependents.

Monitoring and Rebalancing

After implementing investment decisions, the final steps are monitoring and feedback. Monitoring
includes the evaluation of return, risk and ensuring that the behavior of investments or investment
managers is in line with original expectations. Traditionally, the measures for performance have
been limited to percentage gain (return) and standard deviation (risk). However, these measures
cannot be so simply stated when it comes to personal finance.

Portfolio performance should be based on the likelihood of achieving financial goals, not solely on
the level of returns generated. This assessment method is often referred to as shortfall risk, and is
more important and meaningful for the individual than is standard deviation. This can be done by
conducting Monte Carlo analysis both before and during the investment process. Monte Carlo
analysis is a statistical method that generates a wide array of investment outcomes, and highlights
those that are most likely to occur. Using this analysis method better illuminates the likelihood of
reaching financial objectives.

When investment values have significant changes, their allocation can deviate substantially from the
range targeted in the asset allocation step. Returns are cyclical; one asset class may outperform one
year but are in general are unlikely to continue to do so for an extended period of time, with a
general return to the norm. This is why monitoring and rebalancing is important. In this case,
rebalancing is referring only to adjusting portfolio values to the strategic asset allocation selected,
and not because of changes in investment objectives or constraints. This can also apply to changes in
life circumstances, such as change in job, cash flow requirements, time horizon, tax circumstances
and more, which affect the objectives and constraints of the portfolio. Buy and hold has been a
revered investment technique for years, but with the volatility in the stock market, this may not be

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the optimal strategy for all investors. Tax considerations and transaction costs make it preferable to
limit trading activity, but periodic rebalancing is critical in portfolio management.

It is easy to look at the gross percentage that represents the return on a particular investment, but a
variety of things can affect the net return and should not be overlooked. This includes trading costs,
investment commissions and fees, and tax implications. By engaging in a high amount of trading, an
investor may not be improving the performance of the portfolio, but trading costs will assuredly
increase. As for mutual funds, their performance has not been materially different from the
performance of the stock market. Therefore, the only thing that has separated their performance has
been fees charged to invest in them. With a short-term gains rate roughly 20 percentage points
higher than the rate charged on long-term investment gains, tax implications should also be a critical
decision in the portfolio management process.

 Keys to Remember

 To successfully manage an investment portfolio, the advisor must clearly identify an investor’s
objectives and constraints.
 Portfolio management is an ongoing feedback process. It never stops, and changing market
factors and personal investment preferences require advisors to regularly monitor market
conditions and investor responses.
 The concept of diversification and correlation cannot be overly stressed. Even by adding an
investment that is more risky by standard deviation, it can help to increase return while reducing
overall portfolio risk. The portfolio return and risk is the critical focus in investment planning.
 Don’t forget about how human capital can affect the asset allocation process and how its value is
tied to other investments in the portfolio.

4.2.4 Steps in portfolio management

The investment managers will typically follow the following investment management process to
manage a client’s investment portfolio.

1. Planning

This is the most crucial step as it lays down the foundation of the entire process. It comprises of
these tasks:

A. Identification of Objectives and Constraints: The identification of client’s investment

objectives and any constraints is the foremost task in the planning stage. Any desired
outcomes that the client has regarding return and risk are the investment objectives. Any
limitations on the investment decisions or choices are the constraints.

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B. Investment Policy Statement: Once the objectives and constraints are identified, the next
task is to draft an investment policy statement. It is a formal written document created to
govern investment decision making after taking into account the client’s objectives and
constraints.

 Role: Investment policy statement has the following roles to play:

 Endorse long-term discipline in all the portfolio decisions.

 Easily implemented by both current as well as future investment advisors.
 Protect against short-term portfolio reallocation in case the changing markets or the
performance of the portfolio causes overconfidence or panic.

 Elements: An investment policy statement has several of these elements:

 A complete client description providing enough background so that any investment advisor
can understand the client’s situation.
 A purpose with respect to investment objectives, policies, goals, portfolio limitations and
restrictions.
 Identification of responsibilities and duties of all the parties involved.
 A formal statement depicting objectives and constraints.
 A schedule for reviewing the performance of the portfolio and the policy statement.
 Ranges of asset allocation and guidelines regarding rigidity and flexibility when devising or
modifying the asset allocation.
 Instructions for adjustments in the portfolio and rebalancing.

C. Asset Allocation Strategy: This is the last task in the planning stage.

 Strategic Asset Allocation: The investment policy statement and the capital market
expectations are combined to determine the long term weights of the target asset classes,
also known as strategic asset allocation.
 Tactical Asset Allocation: Any short-term change in the portfolio strategy as a result of
the change in circumstances of the investor or the market expectations is a tactical asset
allocation. If the changes become permanent and the policy statement is updated to reflect
the changes, there is a chance that the temporary tactical allocation becomes the new
strategic portfolio allocation.

 The following are the approaches used to execute the strategic asset allocation:

 Passive Investment: These strategies comprise of portfolios that do not respond to any
changes in expectations. Buy and hold and indexing are examples of such passive
strategies.

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 Active Investment: These strategies respond much more to changing expectations. They
aim to benefit from the differences between the beliefs of a portfolio manager concerning
the valuations and those of the marketplace. Making investments according to a particular
style of investment and generating alpha are examples of such active investments.
 Hybrids: These include enhanced index, risk-controlled active and semi-active strategies,
which are hybrids of active and passive strategies. Index tilting is one example of a hybrid
strategy, where the portfolio manager tries to match the risk attributes of a benchmark
portfolio, but at the same time deviates from the same benchmark portfolio allocations to
earn superior returns.

Summary:

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2. Execution

Once the planning stage is completed, execution of the planned portfolio is the next step. This
consists of these decisions:

A. Portfolio Selection: The expectation of the capital markets is combined with decided
investment allocation strategy to choose specific assets for the investor’s portfolio.
Generally, the portfolio managers use the portfolio optimization technique while deciding
the portfolio composition.
B. Portfolio Implementation: Once the portfolio composition is finalized, the portfolio is
executed. Portfolio executions are equally important as high transaction costs can reduce
the performance of the portfolio. Transaction costs include both explicit costs like taxes,
fees, commissions, etc. and implicit costs like bid-ask spread, opportunity costs, market
price impacts, etc. Hence, the execution of the portfolio needs to be appropriately timed
and well-managed.

Summary:

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3. Feedback

Any changes required due to the feedback are analyzed carefully to make sure that they are as per
the long-run considerations. The feedback stage has the following two sub-components:

1. Monitoring and Rebalancing: The portfolio manager needs to monitor and evaluate risk
exposures of the portfolio and compares it with the strategic asset allocation. This is
required to ensure that investment objectives and constraints are being achieved. The
manager monitors the investor’s circumstances, economic fundamentals and market
conditions. Portfolio rebalancing should also consider taxes and transaction costs.
2. Performance Evaluation: The investment performance of the portfolio must be evaluated
regularly to measure the achievement of objectives and the skill of the portfolio manager.
Both absolute returns and relative returns can be used as a measure of performance while
analyzing the performance of the portfolio.

Summary:

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4.3 The concept of diversification

Portfolio Diversification is a foundational concept in investing. It can be a rather basic and easy to
understand concept. However, in its implementation, many investors make catastrophic mistakes
with too much concentration and others settle for average performance because of over
diversification.

Diversification is simply the act of, or the result of, achieving variety. In finance and investment,
portfolio diversification is the risk management strategy of combining a variety of assets to reduce
the overall risk of an investment portfolio.

4.3.1 Purpose of Portfolio Diversification

The purpose of portfolio diversification is portfolio risk management. A risk management plan
should include diversification rules that are strictly followed. Portfolio diversification will lower the
volatility of a portfolio because not all asset categories, industries, or stocks move together. Holding a
variety of non-correlated assets can nearly eliminate unsystematic risk (specific risk).

In other words, by owning a large number of investments in different industries and companies,
industry and company specific risk is minimized. This decreases the volatility of the portfolio
because different assets should be rising and falling at different times; smoothing out the returns of
the portfolio as a whole.

In addition, diversification of non-correlated assets can reduce losses in bear markets; preserving
capital for investment in bull markets. Portfolio optimization can be achieved through proper
diversification because the portfolio manager can invest in a greater number of risk assets (i.e.
stocks) without accepting more risk than planned in the whole portfolio.

In other words, portfolio managers with a target amount of total risk are able to invest a greater
percentage of their assets in risk assets with a diversified portfolio versus a non-diversified portfolio.
This is because holding a variety of non-correlated assets lowers the total risk of the portfolio. This is
why some say diversification is the only free ride.

4.3.2 Over-diversification vs Under-diversification

Can Over Diversification Hurt Investment Returns?

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Some lessons can be over learned. Over diversification is almost as large a problem today as under
diversification. It is common for investors to believe that if a given amount of diversification is good
then more is better. This concept is false.

If adding an individual investment to a portfolio does not reduce the risk of the total portfolio more
than it costs in potential returns then further diversification would be over diversification. Most
experts believe 12 – 25 individual investments are sufficient to reduce unsystematic risk.

4.3.3 How Diversification works

The basic idea behind diversification is that the good performance of some investments balances or
outweighs the negative performance of other investments. For example, let’s assume that you work
for Company XYZ--a beverage company--and you have $1 million to invest. Let’s further assume that
you could invest all $1 million in your employer’s stock, or you could invest 50% in your employer’s
stock and 50% in Company ABC, a healthcare stock.

If you invest all $1 million in Company XYZ stock, and the stock goes from $4 to $2 per share, your
portfolio loses 50% of its value and you end up with $500,000. Now let’s assume that you invested
$500,000 in Company XYZ stock and $500,000 in Company ABC stock. The Company XYZ stock then
goes from $4 to $2 but the Company ABC stock, which has very little in common with the Company
XYZ stock in terms of factors that affect its price, goes from $6 to $7.50. The result is that $500,000 of
your initial investment is now worth only $250,000 (this is the part invested in Company XYZ stock,
which lost 50% of its value) but the other $500,000 is now worth $625,000 (this is the part invested
in Company ABC stock, which rose by 25%). In this scenario, the portfolio goes from $1 million to
$875,000. Still a loss, but not as bad as the $500,000 loss you would have suffered by putting
everything in Company XYZ stock.

The big catch with diversification is that to do it well, the securities in the portfolio need to not “move
together.” That is, the less correlated they are, the better. For example, if you invested everything in
six different bank stocks, it’s fair to assume that what affects one bank stock probably affects the
other bank stocks in your portfolio to some degree. Even though you’ve spread your money over
several securities, you still suffer when one of your bank stocks has bad news. If you instead
purchased a bank stock, a grocery stock, and a healthcare stock, you’d be investing in stocks that are
less correlated with each other--that is, what affects one doesn’t necessarily affect the other. This
diversification is great, but because they’re all stocks, any news that affects the stock market as a
whole (say, an announcement about jobs) affects all of your stocks to some degree, no matter what
industry they’re from.

This is why many investors go one step further and diversify across different asset classes. Stocks,
bonds, and real estate are common asset classes. One common move is to invest in both stocks and

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bonds, because the stock and bond markets are historically negatively correlated, meaning that when
the stock market is up the bond market is usually down and vice versa. Real estate and foreign stocks
are also used to diversify portfolios.

Figuring out how to diversify across asset classes is what drives the practice of asset allocation. For
example, an investor might choose to invest 20% of his portfolio in bonds, 70% in stocks, and 10% in
real estate; but another investor, with different needs and expectations, might choose a different
weighting. Determining the appropriate classes’ weightings for a particular investor is the essence of
asset allocation as a method to optimize diversification.

4.3.4 Why does Diversification matter?

In our example above, you can see the difference that diversifying into just one other stock made. If
you had invested in two more or three more stocks, the results may have been even better. However,
there is no need to get carried away by trying to make a thousand different investments in a
portfolio. That would be expensive and time-consuming, and you may not be able to take meaningful
positions by dividing your money up into such small chunks. This is one reason that mutual funds
and exchange-traded funds are popular--they offer an automatic basket of securities to the investor,
although most experts agree that 25-30 stocks is enough to diversify a stock portfolio in a cost-
effective manner (remember, buying and selling stocks incurs commissions).

Diversification does not guarantee millions in riches, but it does reduce risk. It’s one of the most
fundamental, important investment concepts--one of the first pieces of investment advice most
people get. One only need to think about the Enron employees who placed all of their 401(k) savings
in Enron stock to understand why failing to diversify is like betting the ranch on one roll of the dice.

4.3.5 Approaches towards diversification

Most people are familiar with the concept of diversification, which can be broadly described as "not
putting all your eggs in one basket." Most people know that it’s a good thing to have, but how does
one build a diversified portfolio? There is more than one way to diversify after all. Here are six forms
of diversification that you should include in your portfolio.

A. Diversification by Asset Class

Fund managers and investors often diversify their investments across asset classes and determine
what percentages of the portfolio to allocate to each. Different assets (stocks, bonds, cash, real estate,
commodities) are going to perform differently in various economic environments. For example,
during an economic recovery stocks will likely perform well while in a recession bonds provide

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protection. Commodities, TIPS or cash can protect against the forces of inflation while during a
deflationary environment long-term bonds are often the best investment.

 Stocks—shares or equity in a publicly traded company

 Bonds—government and corporate fixed-income debt instruments
 Real estate—land, buildings, natural resources, agriculture, livestock, and water and mineral
deposits
 Exchange-traded funds (ETFs)—a marketable basket of securities that follow an index,
commodity, or sector
 Commodities—basic goods necessary for the production of other products or services
 Cash and short-term cash-equivalents (CCE)—Treasury bills, certificate of deposit (CD),
money market vehicles, and other short-term, low-risk investments

B. Industry Diversification

Just like getting a mix of individual companies is an important way to diversify your portfolio, having
a balance across the multiple industries in the economy is important too. It’s especially important to
remember to diversify away from the industry with which you are most familiar. The point is, just
like with individual company stocks, it’s not healthy to overweight an industry that you are also
counting on for your paycheck or regional economic health. For instance it’s possible to invest in
multiple industries such as the banking industry, insurance industry, brewery industry, hotel
industry ........... to have industry diversification.

C. Company diversification

In a single industry, there are multiple companies which are engaged in the production and supply of
relatively the same types of goods and services. Having an investment at different industries would
diversify our risk exposures and thus volatility of the returns to be generated. Similarly
diversification is possible when available investment resources are allocated in different companies
which are found under a single industry. For instance the banking industry of Ethiopia includes
various companies engaged in providing commercial banking services. Thus it’s possible to diversify
by allocating investment resources in more than one company.

D. Geographic Diversification

Again, most investors have a home-country bias, preferring the stocks of companies based in their
home country. However, studies show a benefit to diversifying internationally. Allocating our

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investments in a specific geographical area makes our investments vulnerable towards various risks
such as political and forex risks. Thus it advisable to diversify our investments across various
geographical areas to minimize risks which are persistent in some geographical areas only.

E. Time Diversification

There is a possibility of diversifying investment on the bases of time horizon. Thus rather than
investing at one specific period, it’s better to have investments undertaken and also maturing at
different time periods. Time diversification reduces the adverse impact of seasonal risks on your
investment.

4.4 Portfolio Return

Portfolio return refers to the gain or loss realized by an investment portfolio containing several types
of investments. Portfolios aim to deliver returns based on the stated objectives of the investment
strategy, as well as the risk tolerance of the type of investors targeted by the portfolio. Portfolio
returns seek to meet the stated benchmarks, meaning a diversified, theoretical portfolio of stock or
bond holdings, and in some cases, a mix of the two asset classes. Investors typically have one or more
types of portfolios among their investments, and seek to achieve a balanced return on investment
over time.

There are many types of portfolios available to investors ranging from small cap stock funds to
balanced funds consisting of a mix of stocks, bonds and cash. Many portfolios will also include
international stocks, and some exclusively focus on geographic regions or emerging markets.

Many investment managers choose portfolios that seek to offset declines in certain classes of
investments through ownership of other classes that tend to move in opposite directions. For
example, many investment managers tend to mix both bonds and stocks, as bond prices tend to rise
when stocks experience steep drawdowns. This helps to achieve the portfolio’s desired return over
time and to smooth out volatility.

How to determine Portfolio Returns

We have learned about how to calculate the returns on single assets. However, portfolio managers
will have many assets in their portfolios in different proportions. The portfolio manager will have to
therefore calculate the returns on the entire portfolio of assets. The returns on the portfolio are
calculated as the weighted average of the returns on all the assets held in the portfolio. The formula
for portfolio returns is presented below:

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Or simply:

“W” represents the weights of each asset, and “r” represents the returns on the assets. For example, if
an asset constitutes 25% of the portfolio, its weight will be 0.25. Note that sum of all the asset
weights will be equal to 1, as it will represent 100% of the investment. The expected return for a
portfolio can be calculated by using the following simple steps:

 Firstly, the return from each investment of the portfolio is determined which is denoted by r.
 Next, the weight of each investment in the portfolio is determined which is denoted by w.
 Finally, the calculation of expected return equation of the portfolio is calculated by the sum
product of the weight of each investment in the portfolio and the corresponding return from
each investment as given below.
 Expected return = (w1 * r1) + (w2 * r2) + ............. + (wn * rn)

Illustration
Suppose you have predicted the following returns for stocks C and T in three possible states of
nature. What are the expected returns for the two securities? What will be the portfolio return if 300
birr has been invested on stock C and 700 has been invested on stock T from your total 1,000 birr.

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4.5 Measurement of portfolio risk and return

Let’s now look at how to calculate the risk of the portfolio. The risk of a portfolio is measured using
the standard deviation of the portfolio. However, the standard deviation of the portfolio will not be
simply the weighted average of the standard deviation of the two assets. We also need to consider
the covariance/correlation between the assets. The covariance reflects the co-movement of the
returns of the two assets. Unless the two assets are perfectly correlated, the covariance will have the
impact of reduction in the overall risk of the portfolio. So it’s better to have a clear understanding of
correlation and covariance by adopting some real world examples.

4.5.1 Conceptualizing correlation and covariance

What is Covariance?

In mathematics and statistics, covariance is a measure of the relationship between two random
variables. The metric evaluates how much – to what extent – the variables change together. In other
words, it is essentially a measure of the variance between two variables (note that the variance of

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one variable equals the variance of the other variable). However, the metric does not assess the
dependency between variables.

Unlike the correlation coefficient, covariance is measured in units. The units are computed by
multiplying the units of the two variables. The variance can take any positive or negative values. The
values are interpreted as follows:

 Positive covariance: Indicates that two variables tend to move in the same direction.
 Negative covariance: Reveals that two variables tend to move in inverse directions.

In finance, the concept is primarily used in portfolio theory. One of its most common applications in
portfolio theory is the diversification method, using the covariance between assets in a portfolio. By
choosing assets that do not exhibit a high positive covariance with each other, the undiversifiable
risk can be partially eliminated.

Formula for Covariance

The covariance formula is similar to the formula for correlation and deals with the calculation of data
points from the average value in a dataset. For example, the covariance between two random
variables X and Y can be calculated using the following formula (for population):

 For a sample covariance, the formula is slightly adjusted:

Where:

 Xi – the values of the X-variable

 Yj – the values of the Y-variable
 – the mean (average) of the X-variable

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 Ȳ – the mean (average) of the Y-variable

 n – the number of the data points

What is Correlation?

Correlation is another way to determine how two variables are related. In addition to telling you
whether variables are positively or inversely related, correlation also tells you the degree to which
the variables tend to move together.

As stated above, covariance measures variables that have different units of measurement. Using
covariance, you could determine whether units were increasing or decreasing, but it was
impossible to measure the degree to which the variables moved together because covariance does
not use one standard unit of measurement. To measure the degree to which variables move
together, you must use correlation. Correlation standardizes the measure of interdependence
between two variables and, consequently, tells you how closely the two variables move. The
correlation measurement, called a correlation coefficient, will always take on a value between 1
and – 1:

If the correlation coefficient is one, the variables have a perfect positive correlation. This
means that if one variable moves a given amount, the second moves proportionally in the
same direction. A positive correlation coefficient less than one indicates a less than perfect
positive correlation, with the strength of the correlation growing as the number
approaches one.

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If correlation coefficient is zero, no relationship exists between the variables. If one variable
moves, you can make no predictions about the movement of the other variable; they are
uncorrelated.
If correlation coefficient is –1, the variables are perfectly negatively correlated (or inversely
correlated) and move in opposition to each other. If one variable increases, the other
variable decreases proportionally. A negative correlation coefficient, greater than –1
indicates a less than perfect negative correlation, with the strength of the correlation
growing as the number approaches –1.

Covariance vs. Correlation

Covariance and correlation both primarily assess the relationship between variables. The closest
analogy to the relationship between them is the relationship between the variance and standard
deviation. Covariance measures the total variation of two random variables from their expected
values. Using covariance, we can only gauge the direction of the relationship (whether the variables
tend to move in tandem or show an inverse relationship). However, it does not indicate the strength
of the relationship, nor the dependency between the variables.

On the other hand, correlation measures the strength of the relationship between variables.
Correlation is the scaled measure of covariance. It is dimensionless. In other words, the correlation
coefficient is always a pure value and not measured in any units. The relationship between the two
concepts can be expressed using the formula below:

Where:

 ρ( ,Y) – the correlation between the variables X and Y

 Cov(X,Y) – the covariance between the variables X and Y
 σX – the standard deviation of the X-variable
 σY – the standard deviation of the Y-variable

4.5.2 Diversification and the correlation effect

The diversification gains achieved by adding more investments will depend on the degree of
correlation among the investments. As long as the investment returns are not perfectly positively
correlated, there will be diversification of benefits. However, the diversification benefits will be
greater when the correlations are low or negative.

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