Two portfolios can have the same expected return and very different risks. Expectation measures a distribution’s average; variance measures its spread; covariance measures how two quantities move together. This lesson calculates all three from probability weights and uses covariance to explain diversification. Statistics later estimates these quantities from observations.
Learning objectives. By the end of this note you should be able to:
- calculate expectation and variance for a discrete random variable;
- use ;
- calculate and interpret covariance and correlation;
- expand the variance of a two-asset portfolio;
- distinguish zero covariance from independence.
In this lesson
- Location and spread
- Co-movement
- Portfolio variance
- Correlation changes diversification
Before you start
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