Standard Deviation of 2 Assets

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Standard Deviation of 2 Assets

You can use the standard deviation as a measure of risk when you are analyzing your portfolio. Determining the average return in your portfolio is relatively easy, all you need to calculate is the weighted average return. When you are trying to determine the overall risk of your portfolio, it's not so simple.

Thie reason that this calculation is not very easy is because price movements and profits within your portfolio (and the market) are not independent of each other. For you formula hounds, the formula to calculate the standard deviation of 2 assets is:

sd = [ (wgt1 ^2 * s1 ^2) + (wgt2 ^2 * s2 ^ 2) + (2 * w1 * w2 * cov12) ] ^ .5
where
wgt1 is the weight of asset 1
wgt2 is the weight of asset 2
s1 is the standard deviation of asset 1
s2 is the standard deviation of asset 2
cov12 is the covariant of assets 1 and 2

Now, you may ask, what the heck is this used for? This is used to help you determine if you are properly diversifying your portfolio. When an asset reacts to something in the market and the price drops, a properly diversified portfolio would have some asset that offsets this drop. In order to determine if any two assets are properly diversified, run through this calculation. The closer to 0 that you come, the better off you will be.

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