The variance is a measure of variability. It is calculated by taking the average of squared deviations from the mean.

Variance tells you the degree of spread in your data set. The more spread the data, the larger the variance is in
relation to the mean.

Population vs sample variance

Different formulas are used for calculating variance depending on whether you have data from a whole population or a
sample.

Population variance: When you have collected data from every member of the population that you’re
interested in, you can get an exact value for population variance. The population variance formula
looks like this:
Formula Explanation

 σ2 = population variance
 Σ = sum of…
 Χ = each value
 μ = population mean
 Ν = number of values in the population

Sample variance
When you collect data from a sample, the sample variance is used to make estimates or inferences about the population
variance.

The sample variance formula looks like this:

Formula Explanation

 s2 = sample variance
 Σ = sum of…
 Χ = each value
 x̄ = sample mean
 n = number of values in the sample

With samples, we use n – 1 in the formula because using n would give us a biased estimate that consistently
underestimates variability. The sample variance would tend to be lower than the real variance of the population.

Reducing the sample n to n – 1 makes the variance artificially large, giving you an unbiased estimate of variability: it is
better to overestimate rather than underestimate variability in samples.

It’s important to note that doing the same thing with the standard deviation formulas doesn’t lead to completely unbiased
estimates. Since a square root isn’t a linear operation, like addition or subtraction, the unbiasedness of the sample
variance formula doesn’t carry over the sample standard deviation formula.

Steps for calculating the variance

The variance is usually calculated automatically by whichever software you use for your statistical analysis. But you can
also calculate it by hand to better understand how the formula works.
There are five main steps for finding the variance by hand. We’ll use a small data set of 6 scores to walk through the
steps.

Data set

46 6 32 60 5 41
9 2

Step 1: Find the mean

To find the mean, add up all the scores, then divide them by the number of scores.

Mean (x̅)

x̅ = (46 + 69 + 32 + 60 + 52 + 41) ÷ 6
= 50

Step 2: Find each score’s deviation from the mean

Subtract the mean from each score to get the deviations from the mean.

Since x̅ = 50, take away 50 from each score.

Score Deviation from the mean

46 46 – 50 = -4

69 69 – 50 = 19
Score Deviation from the mean

32 32 – 50 = -18

60 60 – 50 = 10

52 52 – 50 = 2

41 41 – 50 = -9

Step 3: Square each deviation from the mean

Multiply each deviation from the mean by itself. This will result in positive numbers.

Squared deviations from the mean

(-4)2 = 4 × 4 = 16

192 = 19 × 19 = 361

(-18)2 = -18 × -18 = 324

102 = 10 × 10 = 100
Squared deviations from the mean

22 = 2 × 2 = 4

(-9)2 = -9 × -9 = 81

Step 4: Find the sum of squares

Add up all of the squared deviations. This is called the sum of squares.

Sum of squares

16 + 361 + 324 + 100 + 4 + 81

= 886

Step 5: Divide the sum of squares by n – 1 or N

Divide the sum of the squares by n – 1 (for a sample) or N (for a population).

Since we’re working with a sample, we’ll use n – 1, where n = 6.

Variance

886 ÷ (6 – 1) = 886 ÷ 5
 Variance

= 177.2

Why does variance matter?

Variance matters for two main reasons:

 Parametric statistical tests are sensitive to variance.

 Comparing the variance of samples helps you assess group differences.

Variance vs standard deviation

The standard deviation is derived from variance and tells you, on average, how far each value lies from the mean. It’s the
square root of variance.

Both measures reflect variability in a distribution, but their units differ:

 Standard deviation is expressed in the same units as the original values (e.g., meters).
 Variance is expressed in much larger units (e.g., meters squared)

Since the units of variance are much larger than those of a typical value of a data set, it’s harder to interpret the variance
number intuitively. That’s why standard deviation is often preferred as a main measure of variability.

However, the variance is more informative about variability than the standard deviation, and it’s used in making statistical
inferences.
What is Standard Deviation?

From a statistics standpoint, the standard deviation of a dataset is a measure of the magnitude
of deviations between the values of the observations contained in the dataset. From a financial
standpoint, the standard deviation can help investors quantify how risky an investment is and
determine their minimum required return on the investment.

Calculating Standard Deviation

We can find the standard deviation of a set of data by using the following formula:
Where:

 Ri – the return observed in one period (one observation in the data set)
 Ravg – the arithmetic mean of the returns observed
 n – the number of observations in the dataset

Standard Deviation Example

An investor wants to calculate the standard deviation experience by his investment portfolio in
the last four months. Below are some historical return figures:

The first step is to calculate Ravg, which is the arithmetic mean:

the arithmetic mean of returns is 5.5%.

Next, we can input the numbers into the formula as follows:

The standard deviation of returns is 10.34%.

Thus, the investor now knows that the returns of his portfolio fluctuate by approximately 10%
month-over-month. The information can be used to modify the portfolio to better the investor’s
attitude towards risk.
If the investor is risk-loving and is comfortable with investing in higher-risk, higher-return
securities and can tolerate a higher standard deviation, he/she may consider adding in some
small-cap stocks or high-yield bonds. Conversely, an investor that is more risk-averse may not
be comfortable with this standard deviation and would want to add in safer investments such
as large-cap stocks or mutual funds

Normal Distribution of Returns

The normal distribution theory states that in the long run, the returns of an investment will fall
somewhere on an inverted bell-shaped curve. Normal distributions also indicate how much of
the observed data will fall within a certain range:

 68% of returns will fall within 1 standard deviation of the arithmetic mean
 95% of returns will fall within 2 standard deviations of the arithmetic mean
 99% of returns will fall within 3 standard deviations of the arithmetic mean

The graphic below illustrates this concept

What Is the Coefficient of Variation (CV)?

The coefficient of variation (CV) is a statistical measure of the dispersion of data points in a data series around the mean. The
coefficient of variation represents the ratio of the standard deviation to the mean, and it is a useful statistic for comparing the degree of
variation from one data series to another, even if the means are drastically different from one another.

Understanding the Coefficient of Variation

The coefficient of variation shows the extent of variability of data in a sample in relation to the mean of the population. In finance, the
coefficient of variation allows investors to determine how much volatility, or risk, is assumed in comparison to the amount of return
expected from investments. Ideally, if the coefficient of variation formula should result in a lower ratio of the standard deviation to
mean return, then the better the risk-return trade-off. Note that if the expected return in the denominator is negative or zero, the
coefficient of variation could be misleading.
The coefficient of variation is helpful when using the risk/reward ratio to select investments. For example, an investor who is risk-
averse may want to consider assets with a historically low degree of volatility relative to the return, in relation to the overall market or
its industry. Conversely, risk-seeking investors may look to invest in assets with a historically high degree of volatility.

While most often used to analyze dispersion around the mean, quartile, quintile, or decile CVs can also be used to understand variation
around the median or 10th percentile, for example.

The coefficient of variation formula or calculation can be used to determine the deviation between the historical mean price and the
current price performance of a stock, commodity, or bond, relative to other assets.

KEY TAKEAWAYS

 The coefficient of variation (CV) is a statistical measure of the relative dispersion of data points in a data series around the mean.
 In finance, the coefficient of variation allows investors to determine how much volatility, or risk, is assumed in comparison to the
amount of return expected from investments.
 The lower the ratio of the standard deviation to mean return, the better risk-return trade-off.
Coefficient of Variation Formula
Below i CV= σ
μ
where:
σ=standard deviation
μ=means the formula for how to calculate the coefficient of variation:

Example of Coefficient of Variation for Selecting Investments

For example, consider a risk-averse investor who wishes to invest in an exchange-traded fund (ETF), which is a
basket of securities that tracks a broad market index. The investor selects the SPDR S&P 500 ETF, Invesco
QQQ ETF, and the iShares Russell 2000 ETF. Then, he analyzes the ETFs' returns and volatility over the past
15 years and assumes the ETFs could have similar returns to their long-term averages.
For illustrative purposes, the following 15-year historical information is used for the investor's decision:

 If the SPDR S&P 500 ETF has an average annual return of 5.47% and a standard deviation of 14.68%,
the SPDR S&P 500 ETF's coefficient of variation is 2.68.
 If the Invesco QQQ ETF has an average annual return of 6.88% and a standard deviation of 21.31%, the
QQQ's coefficient of variation is 3.10.
 If the iShares Russell 2000 ETF has an average annual return of 7.16% and a standard deviation of
19.46%, the IWM's coefficient of variation is 2.72.

Based on the approximate figures, the investor could invest in either the SPDR S&P 500 ETF or the iShares
Russell 2000 ETF, since the risk/reward ratios are approximately the same and indicate a better risk-return
trade-off than the Invesco QQQ ETF.

Covariance provides insight into how two variables are related to one another. More precisely, covariance refers to the measure of
how two random variables in a data set will change together. A positive covariance means that the two variables at hand are
positively related, and they move in the same direction

In mathematics and statistics, covariance is a measure of the relationship between two

random variables. The metric evaluates how much – to what extent – the variables change
together. In other words, it is essentially a measure of the variance between two variables.
However, the metric does not assess the dependency between variables.

Unlike the correlation coefficient, covariance is measured in units. The units are computed by
multiplying the units of the two variables. The variance can take any positive or negative
values. The values are interpreted as follows:

 Positive covariance: Indicates that two variables tend to move in the same direction.
 Negative covariance: Reveals that two variables tend to move in inverse directions.
 In finance, the concept is primarily used in portfolio theory. One of its most common
applications in portfolio theory is the diversification method, using the covariance between
assets in a portfolio. By choosing assets that do not exhibit a high positive covariance with
each other, the unsystematic risk can be partially eliminated.

Formula for Covariance

The covariance formula is similar to the formula for correlation and deals with the calculation
of data points from the average value in a dataset. For example, the covariance between two
random variables X and Y can be calculated using the following formula (for population):

For a sample covariance, the formula is slightly adjusted:

Where:

 Xi – the values of the X-variable

 Yj – the values of the Y-variable
 X̄ – the mean (average) of the X-variable
 Ȳ – the mean (average) of the Y-variable
 n – the number of data points
Covariance measures the total variation of two random variables from their expected values.
Using covariance, we can only gauge the direction of the relationship (whether the variables
tend to move in tandem or show an inverse relationship). However, it does not indicate the
strength of the relationship,

nor the dependency between the variables.

On the other hand, correlation measures the strength of the relationship between variables.
Correlation is the scaled measure of covariance. It is dimensionless. In other words, the
correlation coefficient is always a pure value and not measured in any units.

The relationship between the two concepts can be expressed using the formula below:

Where:

 ρ(X,Y) – the correlation between the variables X and Y

 Cov(X,Y) – the covariance between the variables X and Y
 σX – the standard deviation of the X-variable
 σY – the standard deviation of the Y-variable
What Is Beta?
Beta is a measure of the volatility—or systematic risk—of a security or portfolio compared to the market as a
whole. Beta is used in the capital asset pricing model (CAPM), which describes the relationship between
systematic risk and expected return for assets (usually stocks). CAPM is widely used as a method for pricing
risky securities and for generating estimates of the expected returns of assets, considering both the risk of those
assets and the cost of capital.

 Beta data about an individual stock can only provide an investor with an approximation of how much risk the stock will add to
a (presumably) diversified portfolio.
 For beta to be meaningful, the stock should be related to the benchmark that is used in the calculation.
Volume 75%

What Is Systematic Risk?

Systematic risk refers to the risk inherent to the entire market or market segment. Systematic risk, also known as
“undiversifiable risk,” “volatility” or “market risk,” affects the overall market, not just a particular stock or industry.
This type of risk is both unpredictable and impossible to completely avoid. It cannot be mitigated through
diversification, only through hedging or by using the correct asset allocation strategy.

How Beta Works

A beta coefficient can measure the volatility of an individual stock compared to the systematic risk of the entire
market. In statistical terms, beta represents the slope of the line through a regression of data points. In finance,
each of these data points represents an individual stock's returns against those of the market as a whole.

Beta effectively describes the activity of a security's returns as it responds to swings in the market. A security's
beta is calculated by dividing the product of the covariance of the security's returns and the market's returns by
the variance of the market's returns over a specified period.
Correlation and the Financial Markets
In the financial markets, the correlation coefficient is used to measure the correlation between two securities. For
example, when two stocks move in the same direction, the correlation coefficient is positive. Conversely, when
two stocks move in opposite directions, the correlation coefficient is negative.

If the correlation coefficient of two variables is zero, there is no linear relationship between the variables.
However, this is only for a linear relationship. It is possible that the variables have a strong curvilinear
relationship. When the value of ρ is close to zero, generally between -0.1 and +0.1, the variables are said to
have no linear relationship (or a very weak linear relationship).

For example, suppose that the prices of coffee and computers are observed and found to have a correlation of
+.0008. This means that there is no correlation, or relationship, between the two variables.

The covariance of the two variables in question must be calculated before the correlation can be determined.
Next, each variable's standard deviation is required. The correlation coefficient is determined by dividing the
covariance by the product of the two variables' standard deviations.

Standard deviation is a measure of the dispersion of data from its average. Covariance is a measure of how two
variables change together. However, its magnitude is unbounded, so it is difficult to interpret. The normalized
version of the statistic is calculated by dividing covariance by the product of the two standard deviations. This is
the correlation coefficient.

Positive Correlation
A positive correlation—when the correlation coefficient is greater than 0—signifies that both variables move in
the same direction. When ρ is +1, it signifies that the two variables being compared have a perfect positive
relationship; when one variable moves higher or lower, the other variable moves in the same direction with the
same magnitude.
what Is the Correlation Coefficient?
The correlation coefficient is a statistical measure of the strength of the relationship between the relative
movements of two variables. The values range between -1.0 and 1.0. A calculated number greater than 1.0 or
less than -1.0 means that there was an error in the correlation measurement. A correlation of -1.0 shows a
perfect negative correlation, while a correlation of 1.0 shows a perfect positive correlation. A correlation of 0.0
shows no linear relationship between the movement of the two variables.

Correlation statistics can be used in finance and investing. For example, a correlation coefficient could be
calculated to determine the level of correlation between the price of crude oil and the stock price of an oil-
producing company, such as Exxon Mobil Corporation. Since oil companies earn greater profits as oil prices
rise, the correlation between the two variables is highly positive.

Understanding the Correlation Coefficient

There are several types of correlation coefficients, but the one that is most common is the Pearson correlation
(r). This measures the strength and direction of the linear relationship between two variables. It cannot capture
nonlinear relationships between two variables and cannot differentiate between dependent and independent
variables.

A value of exactly 1.0 means there is a perfect positive relationship between the two variables. For a positive
increase in one variable, there is also a positive increase in the second variable. A value of -1.0 means there is a
perfect negative relationship between the two variables. This shows that the variables move in opposite
directions - for a positive increase in one variable, there is a decrease in the second variable. If the correlation
between two variables is 0, there is no linear relationship between them.

The strength of the relationship varies in degree based on the value of the correlation coefficient. For example, a
value of 0.2 shows there is a positive correlation between two variables, but it is weak and likely unimportant.
Analysts in some fields of study do not consider correlations important until the value surpasses at least 0.8.
However, a correlation coefficient with an absolute value of 0.9 or greater would represent a very strong
relationship.
What is Net Present Value (NPV)?

Net Present Value (NPV) is the value of all future cash flows (positive and negative) over the
entire life of an investment discounted to the present. NPV analysis is a form of intrinsic
valuation and is used extensively across finance and accounting for determining the value of a
business, investment security, capital project, new venture, cost reduction program, and
anything that involves cash flow.

NPV Formula
The formula for Net Present Value is:

Where:

 Z1 = Cash flow in time 1

 Z2 = Cash flow in time 2
 r = Discount rate
 X0 = Cash outflow in time 0 (i.e. the purchase price / initial investment)

Why is Net Present Value (NPV) Analysis Used?

NPV analysis is used to help determine how much an investment, project, or any series of cash
flows is worth. It is an all-encompassing metric, as it takes into account all revenues, expenses,
and capital costs associated with an investment in its Free Cash Flow (FCF).

In addition to factoring all revenues and costs, it also takes into account the timing of each
cash flow that can result in a large impact on the present value of an investment. For example,
it’s better to see cash inflows sooner and cash outflows later, compared to the opposite.
Why Are Cash Flows Discounted?

The cash flows in net present value analysis are discounted for two main reasons, (1) to adjust
for the risk of an investment opportunity, and (2) to account for the time value of money (TVM).

The first point (to adjust for risk) is necessary because not all businesses, projects, or
investment opportunities have the same level of risk. Put another way, the probability of
receiving cash flow from a US Treasury bill is much higher than the probability of receiving
cash flow from a young technology startup.

To account for the risk, the discount rate is higher for riskier investments and lower for a safer
one. The US treasury example is considered to be the risk-free rate, and all other investments
are measured by how much more risk they bear relative to that.

The second point (to account for the time value of money) is required because due to inflation,
interest rates, and opportunity costs, money is more valuable the sooner it’s received. For
example, receiving $1 million today is much better than $1 million received five years from
now. If the money is received today, it can be invested and earn interest, so it will be worth
more than $1 million in five years’ time.

Example of Net Present Value (NPV)

Let’s look at an example of how to calculate the net present value of a series of cash flows. As
you can see in the screenshot below, the assumption is that an investment will return $10,000
per year over a period of 10 years, and the discount rate required is 10%.
The final result is that the value of this investment is worth $61,446 today. It means a rational
investor would be willing to pay up to $61,466 today to receive $10,000 every year over 10
years. By paying this price, the investor would receive an internal rate of return (IRR) of 10%.
By paying anything less than $61,000, the investor would earn an internal rate of return that’s
greater than 10%.

What is the Internal Rate of Return (IRR)?

The Internal Rate of Return (IRR) is the discount rate that makes the net present value (NPV) of a
project zero. In other words, it is the expected compound annual rate of return that will be
earned on a project or investment. In the example below, an initial investment of $50 has a
22% IRR. That is equal to earning a 22% compound annual growth rate.
 When calculating IRR, expected cash flows for a project or investment are given and the NPV
equals zero. Put another way, the initial cash investment for the beginning period will be equal
to the present value of the future cash flows of that investment. (Cost paid = present value of
future cash flows, and hence, the net present value = 0).
Once the internal rate of return is determined, it is typically compared to a company’s hurdle
rate or cost of capital. If the IRR is greater than or equal to the cost of capital, the company
would accept the project as a good investment. (That is, of course, assuming this is the sole
basis for the decision.

In reality, there are many other quantitative and qualitative factors that are considered in an
investment decision.) If the IRR is lower than the hurdle rate, then it would be rejected.

What is the IRR Formula?

The IRR formula is as follows:

Calculating the internal rate of return can be done in three ways:

1. Using the IRR or XIRR function in Excel or other spreadsheet programs (see example
below)
 2. Using a financial calculator
3. Using an iterative process where the analyst tries different discount rates until the NPV
equals zero (Goal Seek in Excel can be used to do this)

Practical Example

Here is an example of how to calculate the Internal Rate of Return.

A company is deciding whether to purchase new equipment that costs $500,000. Management
estimates the life of the new asset to be four years and expects it to generate an additional
$160,000 of annual profits. In the fifth year, the company plans to sell the equipment for its
salvage value of $50,000.

Meanwhile, another similar investment option can generate a 10% return. This is higher than
the company’s current hurdle rate of 8%. The goal is to make sure the company is making the
best use of its cash.

To make a decision, the IRR for investing in the new equipment is calculated below.

Excel was used to calculate the IRR of 13%, using the function, =IRR(). From a financial
standpoint, the company should make the purchase because the IRR is both greater than the
hurdle rate and the IRR for the alternative investment.
What is the Internal Rate of Return Used For?

Companies take on various projects to increase their revenues or cut down costs. A great new
business idea may require, for example, investing in the development of a new product.

In capital budgeting, senior leaders like to know the estimated return on such investments.
The internal rate of return is one method that allows them to compare and rank projects based
on their projected yield. The investment with the highest internal rate of return is usually
preferred.
Internal Rate of Return is widely used in analyzing investments for private equity and venture
capital, which involves multiple cash investments over the life of a business and a cash flow at
the end through an IPO or sale of the business.

Thorough investment analysis requires an analyst to examine both the net present value
(NPV) and the internal rate of return, along with other indicators, such as the payback period, in
order to select the right investment. Since it’s possible for a very small investment to have a
very high rate of return, investors and managers sometimes choose a lower percentage
return but higher absolute dollar value opportunity.

Also, it’s important to have a good understanding of your own risk tolerance, a company’s
investment needs, risk aversion, and other available options.