Mean-Variance Analysis
Contents
Exploring Mean-Variance Analysis: Balancing Risk and Reward
Understanding Mean-Variance Analysis
What Is a Mean-Variance Analysis?
Mean-variance analysis involves assessing risk, measured as variance, against expected return to aid investment decisions. Investors utilize this analysis to evaluate the trade-off between risk and reward, aiming to identify investments with the highest potential return for a given level of risk or the lowest risk for a desired return.
Key Takeaways:
- Mean-variance analysis helps investors evaluate investment decisions by balancing risk and reward.
- It considers the variance, representing the spread of returns of a security, and the expected return, expressing the anticipated return on investment.
- Investments with lower variance and the same expected return are preferred, while those with higher returns and similar variance are favored.
- Modern portfolio theory incorporates mean-variance analysis to construct diversified portfolios and mitigate risk during market fluctuations.
Understanding Mean-Variance Analysis
Mean-variance analysis forms a critical component of modern portfolio theory, assuming investors make rational decisions with complete information. It evaluates the variability (variance) and anticipated return of investments to optimize portfolio composition. By selecting securities with varying levels of risk and return, investors aim to achieve a balanced portfolio capable of withstanding market volatility.
Example of Mean-Variance Analysis
To illustrate mean-variance analysis, consider an investor's portfolio comprising two investments:
- Investment A: $100,000 with an expected return of 5%
- Investment B: $300,000 with an expected return of 10%
After calculating the weights of each asset in the portfolio, the total expected return and portfolio variance can be determined. Despite the complexities involved in calculating portfolio variance, incorporating the correlation between investments and their standard deviations enables a comprehensive assessment of risk.