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Finance: What is co-variance?
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Finance: What is co-variance? 8 Views


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What is covariance? Covariance is the comparison of how assets move in the markets. Positive covariance is when assets move in tandem, such as when FAANG stocks all pose gains or losses on the same day. A negative covariance is an inverse move between assets, such as when the US dollar gets weaker and gold gets stronger.

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00:00

Finance allah shmoop what is co variance while co variance

00:08

is a way to tell if two investments will both

00:11

head to millionaire acres together or to the poor house

00:15

together or if one is headed to millionaire acres while

00:18

the other is headed Teo you know the poor house

00:21

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

00:24

it basically comes in these three flavors Positive co variance

00:28

which means the investments both either grow in value or

00:32

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

00:36

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

00:40

that as one investment grows well the other loses like

00:44

loses value also typically in a linear fashion you know

00:47

kind of graphically linear and then you have zero co

00:50

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

00:54

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

00:57

just not really varying together They may both grow together

01:01

but in a non linear kind of curvy almost random

01:04

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

01:08

do it in a straight line of kind of way

01:10

right Well co variances used to help investors make sure

01:13

their portfolios are adequately diversified after all if our when

01:19

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

01:22

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

01:26

Kind of kind of want to hedge your bets there

01:27

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

01:29

in which all the investments are in companies that make

01:32

different kinds of hand held tech like smartphones and tablets

01:36

and smart watches and you know adult aides of different

01:40

flavors and forms So these investments in our portfolio will

01:44

almost all certainly have a positive co variance with each

01:47

other like they all kind of have the same buyers

01:50

and sellers and appetites and market swings And then the

01:53

surgeon general one day determines that the radiation from handheld

01:56

tech causes monster ism The value of our portfolio will

02:00

hit rock bottom fast stirred on an album of spoken

02:03

word poetry by vladimir putin if instead we had paid

02:07

attention to all that positive co variance data and try

02:10

to get some investments with negative co variance is well

02:14

we might not be looking through the want ads and

02:17

selling plasma every day to pay for food a portfolio

02:20

With a number of pairs of investments with negative co

02:22

variances would mean that while some of our tech stocks

02:26

might have plummetted our monster defense stocks might have skyrocketed

02:30

All right So how do we calculate co variance Well

02:33

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

02:36

formula which has us take one investments returns subtract the

02:40

mean return from each of those returns And repeat that

02:43

for the other investments multiplying all the pairs together to

02:46

sum up those values Wait can we just do this

02:49

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

02:51

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

02:53

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

02:56

need to find the means The averages of investment one

02:59

and investment to well to get that for investment one

03:02

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

03:05

point one five point three five hundred francs having and

03:07

if i had a total of twenty seven point two

03:09

by five giving us an average there Five point four

03:12

for for investment too We had three point three of

03:14

your own and these are like percent returns on bonds

03:17

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

03:18

a total seventeen point nine five by five and we

03:21

get three point five eight Right now we subtract the

03:23

mean from each individual return So for investment one that

03:27

means subtracting the mean of five point four four from

03:31

each data point you get five point one five point

03:33

three five point four five seven five seven Not to

03:35

be mean But that means we also need to subtract

03:38

the mean of investment to which was that three point

03:40

five eight from each of those data points and so

03:43

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

03:45

should look so next up multiply the matched pairs of

03:47

points like negative zero point three four times negative zero

03:51

point two eight and then negative point one four times

03:53

Negative point one eight and so on All right time

03:55

to some All those values to get point o nine

03:58

five two plus point two five two plus uh negative

04:02

went for a a aa plus Pulling on three One

04:06

two and five seven two gives us point two oh

04:09

four There we go What We finish up dividing that

04:11

Some by one last the number of hairs of data

04:14

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

04:16

that thing will divide that by four Which gives us

04:19

a cove Arians finally of point Oh five one What

04:23

the hell does that mean Well that positive cove arians

04:25

means that in general as investment one gains value in

04:28

general so too does investment to or that in general

04:32

as investment one loses value so too does investment to

04:36

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

04:38

to have some investments with positive co variances but the

04:41

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

04:45

cove Arians pairs of investments maybe kick in a few

04:48

investments to the curb in favor of some that produced

04:51

negative co variances Good idea no matter how attached you

04:54

are to a particular investment or sector of the economy

04:57

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

05:00

what are other ways we can do A ploy to

05:03

find co variance Well we can calculate the correlation coefficient

05:08

a k a the r value r r squared value

05:11

of the data points And then multiply that value by

05:14

both the standard deviation of the ecs data and the

05:17

standard deviation of the wide data Okay well the individual

05:20

standard deviations and our values can be quickly calculated using

05:23

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

05:27

like that using a graphing calculator on those same returns

05:30

from investments one into from before while we found our

05:33

to be point nine o two one exit standard deviation

05:36

to be point two six eight and wise standard deviation

05:39

be point two one six eights is just different Pairs

05:42

of investments Like a bond portfolio How correlated worthy Well

05:45

when we multiply point nine o two one by point

05:48

two six away and then by point two one six

05:51

eight we get a co variance love wait for it

05:53

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

05:56

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

05:59

cove Arians means that the two investments will probably either

06:02

both grow in value over same time period or probably

06:04

lose value together over the same time period They may

06:07

grow or lose value of different race but whatever direction

06:11

one goes in well the other follows Think about him

06:13

Like penguins were kind of you know sniffing each other

06:16

well A negative co variance will mean that is one

06:18

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

06:22

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

06:25

good thing to have stabilized Report Follow at least in

06:27

the short term a well diversified portfolio should have enough

06:30

pairs of investments or combinations of investments that have negative

06:33

co variances so that they protect you in the really

06:36

ugly scenarios Right now we just have to figure out

06:39

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

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