Mean-Variance Analysis

What is a 'Mean-Variance Analysis'

Mean-variance analysis is the process of weighing risk, expressed as
variance, against expected return. Investors use mean-variance analysis to make
decisions about which financial instruments to invest in, based on how much risk
they are willing to take on in exchange for different levels of reward. Mean-
variance analysis allows investors to find the biggest reward at a given level of
risk or the least risk at a given level of return.

BREAKING DOWN 'Mean-Variance Analysis'

Mean-variance analysis is one part of modern portfolio theory, which assumes
that investors will make rational decisions about investments if they have
complete information. One assumption is that investors want low risk and high
reward. There are two main parts of mean-variance analysis: variance and
expected return. Variance is a number that represents how varied, or spread out,
the numbers in a set are. For example, variance may tell how spread out the
returns of a specific security are on a daily or weekly basis. The expected return
is a probability expressing the estimated return of the investment in the security.
If two different securities have the same expected return, but one has lower
variance, the one with lower variance is the better pick. Similarly, if two different
securities have approximately the same variance, the one with the higher return
is the better pick.

In modern portfolio theory, an investor would choose different securities to invest

in with different levels of variance and expected return.

Sample Mean-Variance Analysis

It is possible to calculate which investments have the greatest variance and
expected return. Assume the following investments are in an investor's portfolio:

Investment A: Amount = $100,000 and expected return of 5%

Investment B: Amount = $300,000 and expected return of 10%

In a total portfolio value of $400,000, the weight of each asset is:

Investment A weight = $100,000 / $400,000 = 25%

Investment B weight = $300,000 / $400,000 = 75%

Therefore, the total expected return of the portfolio is the weight of the asset in
the portfolio multiplied by the expected return:

Portfolio expected return = (25% x 5%) + (75% x 10%) = 8.75%Portfolio variance

is more complicated to calculate, because it is not a simple weighted average of
the investments' variances. The correlation between the two investments is 0.65.
The standard deviation, or square root of variance, for Investment A is 7 percent,
and the standard deviation for Investment B is 14 percent. 

In this example, the portfolio variance is:

Portfolio variance = (25% ^ 2 x 7% ^ 2) + (75% ^ 2 x 14% ^ 2) + (2 x 25% x 75%

x 7% x 14% x 0.65) = 0.0137

The portfolio standard deviation is the square root of the answer: 11.71 percent

Variance Formula:

Where w indicates the percentage allocated to the respective classes. The

portfolio’s standard deviation is just the square root of its variance.