Covariance can increase diversification in the asset portfolio. Adding assets with negative covariance to the portfolio reduces the overall risk. Initially, these risks decrease rapidly; As additional assets are added, they slowly decrease. Diversified risk cannot be significantly reduced by more than 25 different shares in the portfolio. However, including more assets with negative covariance means that risk decreases more quickly.
Covariance has some limitations. While covariance can show the trend between two assets, it cannot be used to calculate the strength of the relationship between prices. Determining the coefficient of correlation between assets is a better way to measure the strength of the relationship.
An additional disadvantage of using variance is that the measurement is subject to skew due to the presence of outliers in the underlying data. Thus, large price movements in one period may skew the general volatility of the price chain and provide an unreliable statistical measure of the nature of the trend among assets.
Use of the modern portfolio theory of heterogeneity
Modern portfolio theory (MPT) uses covariance as an important component in constructing portfolios. MPT assumes that investors are risk averse yet still seek the best possible return. Thus MPT attempts to define efficient limits for the mix of assets in the portfolio, or the optimum point at which the risk-return relationship is most beneficial. Effective Limits Calculates the maximum return for a portfolio against the amount of risk for the underlying asset group. The goal is to create a group of assets with a general standard deviation less than the standard deviation of individual securities. The graph of the effective limits is curved, which shows how high volatility assets can be mixed with low volatility assets to maximize return but minimize the impact of large price fluctuations. By diversifying the assets in the portfolio, investors can reduce risk while obtaining returns on their investment.
Covariance is a statistical measure of how two assets move in relation to each other. It provides diversification and reduces overall portfolio volatility. A positive covariance indicates that two assets move in tandem. Negative covariance indicates that two assets are moving in opposite directions.
When creating the portfolio, it is important to try to minimize overall risk and volatility while striving to achieve a positive rate of return. Analysts use historical price data to determine which assets will be included in the portfolio. By including assets that show negative covariance, the overall volatility of the portfolio will be reduced.
The covariance between two specific assets is calculated through an equation that includes returns to historical assets as independent and dependent variables, plus the historical average of each individual asset price over an equivalent number of trading periods for each asset. The formula takes the daily return minus the average return for each asset, multiplied by each other, and then divided by the number of trading periods for the respective timeframes that have been measured.