Covariance

What is Covariance?

Covariance is a statistical term used in security and portfolio evaluation, and it measures the amount which two assets move in relation to each other. A positive covariance means the assets move in the same direction, and the larger the value, the greater one asset moves in relation to the other.

An example of covariance is as follows:

  • Stock A has a covariance to Stock B of +1.4
  • For every $1 increase of Stock B, Stock A will increase by $1.4

Covariance is typically calculated by multiplying the correlation between the variables (correlation coefficient) by the standard deviation of each variable.

For a well-diversified portfolio, it is desirable to hold assets which do NOT have a positive covariance (or at least have a very low value). This is because a high covariance would mean that if one asset started to lose money, they all would, thus defeating the point of a diversified portfolio.

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