Follow-up: Why Variance Matters

Jan 2, 2007 by

Having higher variance is like having a classroom of students that score (1,1,2,3,3) instead of scoring (2,2,2,2,2). All things being equal, people should prefer to have an investment portfolio that provides stable returns than wildly varying returns. Variance is a measure of dispersion; people usually prefer less dispersion when investing.

For instance, it is probably better to have a portfolio that has an average return of 7% a year over ten years, with the return between 6% and 8% over each of those years than to have a portfolio with an average return of 7% over ten years with an average return of 1% to 13% over each of those years. While both portfolios could produce the same overall profit, all things being equal, people should prefer the more stable portfolio.

There were two take-away messages from my last post:

  • The variance of a portfolio can be decreased by diversifying (buying more things)
  • A portfolio with evenly-sized investments has lower variance than a portfolio in which investments are of differing sizes (even if the investments are in the same equities)

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3 Comments

  1. Jonathan West

    One thing that’s important to note, though, is that you don’t want to look at the averages of the per-year growth rates. Instead, you want to look at the total growth rate for the entire period.

    Having growth rates of 5%, 5%, and 5% doesn’t necessarily imply the same growth rate as 1%, 1%, 13%, even though the average is the same.

    Just a point of clarification.

  2. Jason

    I believe this emphasizes the need for “normal” investors to make sure that they are invested in funds rather than stocks. What I’ve seen is many people arent even aware of the actual point of diversifying and will jump right into stocks!

  3. This is also written the emphasize the importance of investing in multiple stocks or funds, as well as the need to do so in somewhat even increments.

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