How Variance Can Improve Your Investment Strategy?

Markets are sometimes unpredictable and asset prices fluctuate over time. Due to these uncertainties, investors face unexpected losses, make uninformed decisions, and struggle with risk management. To sort out these challenges, investors need a reliable method to measure and manage risk effectively.

That way is variance, it plays a crucial role in shaping a strong investment strategy. It helps investors to understand how much an asset’s return deviates from the average.

• High variance means greater risk, potential for gains, and significant losses.

• low variance indicates more stable returns.

Investors might unknowingly take on too much risk or miss opportunities for higher returns without considering variance. However, with variance analysis, they make an informed decision and improve their investment strategy.

In this blog, we’ll explore variance and how it is helpful for better investment. Also, explore how to calculate variance from raw data.

What is Variance?

Variance is a statistical measure that tells us how the set of numbers is spread out from the mean. In finance, it is used to measure the dispersion of returns around the average return of an investment. It depends on high and low variance:

• High variance indicates greater volatility and risk. Returns can swing wildly, offering the potential for high gains, and significant losses.

• Low variance suggests more stable and predictable returns. It is generally associated with lower risk.

How Variance Helps to Make Better Investment Strategy?

Variance helps investors to assess the volatility of their investments. Here’s a breakdown of how it is helpful:

• Measure Investment Risk: Variance provides a numerical measure of how much an investment’s returns fluctuate. A higher variance means greater volatility and indicates a riskier investment. This helps investors to understand the potential for significant swings in their investment’s value.

• Help in Portfolio Diversification: It can aid investors in building a diversified stock portfolio by analyzing assets. Combining assets with different variances and correlations reduces overall portfolio risk and leads to a better risk-reward balance.

• Risk Adjusted Returns: Variance is used in calculating risk-adjusted performance measures like the Sharpe ratio. These measures provide a more accurate assessment of an investment's performance by considering the level of risk taken to achieve those returns.

• Comparative Analysis: It helps investors to compare the performance of different investments or portfolio managers on a level playing field. This takes into account their respective risk levels.

• Guide in Decision Making: Understanding variance helps investors decide whether to hold or adjust their investments during market ups and downs. If the variance of assets increases unexpectedly, it may signal higher risk and unbalanced portfolio rebalancing.

• Improve Predictability for Returns: Already estimated variance helps investors estimate future volatility and potential returns. This thing is important for making long-term investment plans and avoiding unnecessary risks.

• Identifying Stable Investments: Investors always want stability in businesses. That’s why if the variance of return is low, then it helps to decide whether their investment is secure or not.

Continue your reading to know how to calculate variance to make an informed decision.

How to Calculate the Variance?

To calculate the variance for improvement of your investing strategy and reducing risk, use the below formula:

Let’s make it more simple to understand with the help of an example:

Example:

Calculate the return variance to guess whether your investment is risky or not. Suppose you have the annual returns for an investment: 10%, 5%, -2%, 8%, and 1%.

Calculation

Data: 10, 5, -2, 8, 1 (we’ll treat percentages as whole numbers for simplicity)

Calculate the average of these returns by dividing the sum of all data values:

Mean: (10 + 5 - 2 + 8 + 1) / 5 = 22 / 5 = 4.4

After finding the mean, calculate the squared difference by subtracting the mean from all the data one by one, then square these.

Now put values in the variance formula:

σ2 = 1/ 5 (97.2) = 0.2 (97.2) = 19.44.

The variance of your return is 19.44. If you’re managing other business tasks like export or import, doing deals or meetings with partners, and don’t have time for manual calculation, use a variance calculator for quick and detailed results in seconds.

Interpretation:

The variance of 19.44 shows that the investment has risk. Whether this is good or bad depends on the investor’s risk tolerance.

Variance is an important thing for any business and investment. It helps investors to measure risk and make informed decisions. By understanding variance, investors can assess the stability of potential investments, diversify their portfolios, optimize returns, and apply risk management strategies.