You are reading the 2026 curriculum (exams up to November 2026). Sitting in February 2027 or later? Go to the 2027 Quantitative Methods guide.
Portfolio expected return, variance and the role of correlation
A portfolio's expected return is the weighted average of its assets' expected returns. Its risk is not: variance adds a covariance term for every pair, so the lower the correlation, the lower the portfolio's standard deviation. Unless correlation is +1, the mix is less risky than the weighted average of its parts.
Before this: Covariance and correlation, Probability Trees and Conditional Expectations
On the exam
- Calculate and interpret the expected value, variance, standard deviation, covariances, and correlations of portfolio returns
Calculate and interpret the expected return, variance, standard deviation, covariances and correlations of portfolio returns. Expect a two-asset standard deviation where the cross term is the whole point, a correlation from a covariance, and a question on what a lower correlation does.
How deeply to learn each part
- Know the idea
- Understand it in general. It frames other topics, but you will not calculate with it.
- Use it
- Understand it well enough to solve a question with it. Recognize when it applies.
- Memorize
- Learn it by heart. The exam will not give it to you.
You know this one. The full lesson is folded away. The takeaways, formulas and checkpoint below are your quick refresher, and the checkpoint is a fair test of whether you still do.
You tested strong here. The full lesson is folded away. The takeaways, formulas and checkpoint below are your quick refresher, and the checkpoint is a fair test of whether you still know it.
How do you find a portfolio’s expected return?
The expected return on the portfolio is the weighted average of the expected returns of its assets. The weights are each holding’s share of the portfolio’s value, so they add to 1.
Everything in this lesson uses one running example. An investor puts 60% in an equity fund (expected return 9%, standard deviation 18%) and 40% in a bond fund (expected return 4%, standard deviation 6%). The correlation between the two funds is 0.2.
A portfolio holds 60.00% in asset 1 (expected return 9.00%) and the rest in asset 2 (expected return 4.00%). The portfolio's expected return is closest to:
0.6 × 9 + 0.4 × 4 = 7.00%
Portfolio expected return7.00%
- 0.6×9+(0.4×4)=in percent
- 0.6ENTER9×0.4ENTER4×+in percent
ENTER enter (on the HP, puts the number on the stack)
Expected return is the easy part: the weights tell you the whole story, and how the assets move together plays no role. Risk is different.
How do two returns move together?
Covariance is the probability-weighted average of the product of the two returns’ deviations from their own expected values.
Read the sign like this:
- Positive: when one return is above its expected value, the other tends to be above its own too (and below together). Average positive relationship.
- Negative: when one is above, the other tends to be below. Average inverse relationship.
- Zero: the returns are unrelated in this linear sense.
The covariance of a return with itself is its variance: Cov(R, R) = σ². That is why variances sit on the diagonal of the covariance matrix later in this lesson.
Covariance is hard to read because its size depends on how volatile the assets are. Correlation removes that by dividing by both standard deviations, so it has no units and lies between −1 and +1.
Most exam questions give you the correlation and ask you to rebuild the covariance:
Two assets have a correlation of 0.25 and standard deviations of 20.00% and 12.00%. The covariance of their returns is closest to:
0.25 × 0.2 × 0.12 = 0.006
Covariance, Cov(R₁, R₂)0.006
- 0.25×0.2×0.12=
- 0.25ENTER0.2×0.12×
ENTER enter (on the HP, puts the number on the stack)
Exam tip Pick one unit system and stay in it. Decimals (0.18, 0.0324) or percent (18, 324), never a mixture.
How do you calculate the risk of a two-asset portfolio?
Portfolio variance has three parts: each asset’s own variance scaled by its squared weight, and a cross term that counts the covariance twice.
The standard deviation is the square root, and it is the number that carries the same units as the returns.
A portfolio is 60.00% in asset 1 (standard deviation 18.00%) and 40.00% in asset 2 (standard deviation 6.00%). The correlation is 0.2. The portfolio variance is closest to:
0.6² × 0.18² + 0.4² × 0.06² + 2 × 0.6 × 0.4 × 0.2 × 0.18 × 0.06 = 0.013277
Portfolio variance (decimal)0.0133
- 0.6x²×0.18x²+(0.4x²×0.06x²)+(2×0.6×0.4×0.2×0.18×0.06)=the variance as a decimal
x² square
- 0.6ENTER×0.18ENTER××0.4ENTER×0.06ENTER××+2ENTER0.6×0.4×0.2×0.18×0.06×+the variance as a decimal
ENTER enter (on the HP, puts the number on the stack)
Why does a lower correlation reduce risk?
Only the cross term depends on the correlation. Hold the weights and the two standard deviations fixed, move ρ, and the expected return stays at 7.0% while the standard deviation changes.
| Correlation | Portfolio standard deviation | Expected return |
|---|---|---|
| +1.0 | 13.20% (the weighted average) | 7.0% |
| +0.5 | 12.18% | 7.0% |
| +0.2 | 11.52% | 7.0% |
| 0.0 | 11.06% | 7.0% |
| −0.5 | 9.82% | 7.0% |
| −1.0 | 8.40% | 7.0% |
At ρ = +1 the formula is a perfect square, so σₚ = w₁σ₁ + w₂σ₂ and there is no gain. Any lower correlation pulls σₚ below that line. The risk reduction from holding assets that do not move in step is the diversification benefit , and it grows as the correlation falls.
Try this 0 of 3
- Set the correlation to −1, then find the mix with zero risk
- Set the correlation to +1 and compare σp with the weighted average of the two σs
- Find a mix that is less risky than the bond fund on its own
- All mixes of the two funds
- ρ = +1: no diversification
60% Equity fund and 40% Bond fund with correlation 0.20: expected return 7.00%, risk 11.52%, against 13.20% for a straight average of the two risks.
Portfolio variance, term by term
- w₁²σ₁² (Equity fund) 0.011664
- w₂²σ ₂² (Bond fund) 0.000576
- 2w₁w₂ρσ₁σ₂ (cross term) 0.001037
- Variance 0.013277 (dashed mark: 0.017424, the variance if ρ = +1)
Show working
E(Rp) = w₁E(R₁) + w₂E(R₂) = 0.6 × 9.00% + 0.4 × 4.00% = 7.00%
σ²p = w₁²σ₁² + w₂²σ₂² + 2w₁w₂ρσ₁σ₂ = 0.6² × 0.18² + 0.4² × 0.06² + 2 × 0.6 × 0.4 × 0.2 × 0.18 × 0.06
= 0.011664 + 0.000576 + 0.001037 = 0.013277
σp = √0.013277 = 11.52% (the weighted average of the σs, 13.20%, is right only when ρ = +1)
Covariance = ρσ₁σ₂ = 0.2 × 0.18 × 0.06 = 0.00216
- 0.6×0.18×0.6×0.18=STO10.011664
- 0.4×0.06×0.4×0.06=STO20.000576
- 2×0.6×0.4×0.2×0.18×0.06=cross term 0.001037
- +RCL1+RCL2=variance 0.013277
- √x0.1152, so 11.52%
STO store · RCL recall a stored number · √x square root
- 0.6ENTER0.18×0.6×0.18×0.011664
- 0.4ENTER0.06×0.4×0.06×+0.01224
- 2ENTER0.6×0.4×0.2×0.18×0.06×+variance 0.013277
- g√x0.1152, so 11.52%
ENTER enter (on the HP, puts the number on the stack) · g blue shift key · √x square root
Display: 0.1152
- Own-variance terms Memorize wᵢ²σᵢ², always positive
- Covariance terms Memorize 2wᵢwⱼCov for every pair
- Positive covariance adds risk; returns move together
- Zero covariance adds nothing; returns unrelated
- Negative covariance subtracts risk; this is the diversification benefit
-
- ρ = +1 Memorize σₚ is the weighted average of the two σs; no diversification benefit
- ρ between −1 and +1 Memorize σₚ below the weighted average; the lower ρ, the lower σₚ
- ρ = −1 Use it σₚ = |w₁σ₁ − w₂σ₂|; can reach zero
Notice that the ρ = 0 row equals what you get by forgetting the cross term altogether. Dropping it is the same as assuming the funds are unrelated, which is rarely true and never the right answer when the question gives you a covariance.
Go deeper Removing all risk with perfectly negative correlation
At ρ = −1 the variance is a perfect square again: σₚ = |w₁σ₁ − w₂σ₂|. It reaches zero when w₁σ₁ = w₂σ₂, which gives w₁ = σ₂ ÷ (σ₁ + σ₂).
For the two funds that is 6 ÷ (18 + 6) = 25% in equity and 75% in bonds. Check: 0.25 × 18% = 4.5% and 0.75 × 6% = 4.5%, so the two terms cancel. In practice no two real assets are perfectly negatively correlated, so risk is reduced but not removed.
Go deeper Where the cross term comes from
The portfolio return is w₁R₁ + w₂R₂. Its variance is the expected squared deviation from its mean. Multiplying out (w₁(R₁ − ER₁) + w₂(R₂ − ER₂))² gives w₁² times the first variance, w₂² times the second, and two copies of w₁w₂ times (R₁ − ER₁)(R₂ − ER₂). Taking expectations turns that last product into the covariance. The factor of 2 appears because the cross product occurs twice.
What changes when there are more than two assets?
The same logic extends to any number of assets. List every covariance in a covariance matrix , with the variances on the diagonal, and weight each cell by the product of its two weights.
The matrix is a mirror image across the diagonal, because Cov(i, j) = Cov(j, i). So n assets need n variances but only n(n − 1) ÷ 2 distinct covariances.
As n grows, covariance terms outnumber variance terms: ten assets give 10 variance cells and 90 off-diagonal cells. In a large portfolio, how the assets move together matters more than how risky each one is alone.
Go deeper Why a bigger covariance is not a higher correlation
Take two equity funds with covariance 0.0018 and standard deviations 5% and 4.5%: ρ = 0.0018 ÷ (0.05 × 0.045) = 0.80. Take two bond funds with covariance 0.00028 and standard deviations 1.5% and 2.0%: ρ = 0.00028 ÷ (0.015 × 0.02) = 0.93.
The equity pair has a covariance more than six times larger, yet the bond pair is more tightly correlated. The equity funds are simply more volatile. To compare how closely pairs move together, compare correlations. To compute portfolio variance, you still need the covariances.
Go deeper Forecast versus sample covariance
The covariance in this lesson is forward-looking: it is an expected value, so there is no n − 1. When you estimate it from n past observations of two return series, the sample covariance sums the products of deviations from the sample means and divides by n − 1, as in the statistical measures lesson.
Go deeper Mean–variance analysis
Mean–variance analysis evaluates investments using only expected return (reward) and variance of return (risk). It needs just the inputs of this lesson: expected returns, variances and covariances. It holds exactly when investors are risk averse and either returns are normally distributed or investors have quadratic utility. It remains a useful approximation when those conditions fail, which is why it underlies the efficient frontier in Portfolio Management.
Memorize this
MemorizeTwo-asset portfolio in four lines
| Quantity | Formula |
|---|---|
| Expected return | |
| Variance | |
| Covariance | |
| Correlation |
Memory hook Square each weight with its own variance, then multiply the weights for the cross term and double it, because Cov(1,2) and Cov(2,1) are the same number.
Know it cold Return averages; risk does not. Cov(R, R) = σ². Weights sum to 1. With n assets: n variances and n(n − 1)/2 distinct covariances.
MemorizeCorrelation and diversification
| Correlation | Portfolio σ | Benefit |
|---|---|---|
| +1 | weighted average of the σs | none |
| between −1 and +1 | below that average | some |
| −1 | risk can reach zero |
Memory hook Correlation is the only dial. At +1 the cross term is as large as it can be and the formula collapses to a straight average.
Know it cold Lower correlation lowers σₚ and leaves E(Rₚ) unchanged. Compare pairs by correlation, never by covariance alone.
- Own-variance terms Memorize wᵢ²σᵢ², always positive
- Covariance terms Memorize 2wᵢwⱼCov for every pair
- Positive covariance adds risk; returns move together
- Zero covariance adds nothing; returns unrelated
- Negative covariance subtracts risk; this is the diversification benefit
-
- ρ = +1 Memorize σₚ is the weighted average of the two σs; no diversification benefit
- ρ between −1 and +1 Memorize σₚ below the weighted average; the lower ρ, the lower σₚ
- ρ = −1 Use it σₚ = |w₁σ₁ − w₂σ₂|; can reach zero
Quick example
Weights 0.5, 0.3 and 0.2 in assets expected to return 10%, 6% and 3%. 0.5 × 10 + 0.3 × 6 + 0.2 × 3 = 7.4%.
- 0.5×10+(0.3×6)+(0.2×3)= 7.4
- 0.5ENTER10×0.3ENTER6×+0.2ENTER3×+ 7.4
ENTER enter (on the HP, puts the number on the stack)
Quick example
Two equally likely periods. In the first, asset 1 is 3 above its mean and asset 2 is 2 above. In the second, they are 1 and 4 below. Cov = 0.5 × (3 × 2) + 0.5 × (−1 × −4) = 5 (%²). Positive: the returns sit on the same side of their means.
- 0.5×3×2+(0.5×1+|-×4+|-)= 5
+|- change sign
- 0.5ENTER3×2×0.5ENTER1CHS×4CHS×+ 5
ENTER enter (on the HP, puts the number on the stack) · CHS change sign
Quick example
Correlation 0.4, standard deviations 20% and 10%. 0.4 × 0.20 × 0.10 = 0.008.
- 0.4×0.2×0.1= 0.008
- 0.4ENTER0.2×0.1× 0.008
ENTER enter (on the HP, puts the number on the stack)
Quick example
Covariance 0.0108, standard deviations 24% and 15%. 0.0108 ÷ (0.24 × 0.15) = 0.30.
- 0.0108÷(0.24×0.15)= 0.3
- 0.0108ENTER0.24ENTER0.15×÷ 0.3
ENTER enter (on the HP, puts the number on the stack)
Quick example
50/50 mix, standard deviations 14% and 8%, correlation 0.5. 0.25 × 0.0196 + 0.25 × 0.0064 + 2 × 0.25 × 0.5 × 0.14 × 0.08 = 0.0049 + 0.0016 + 0.0028 = 0.0093.
- 0.5x²×0.14x²+(0.5x²×0.08x²)+(2×0.5×0.5×0.5×0.14×0.08)= 0.0093
x² square
- 0.5ENTER×0.14ENTER××0.5ENTER×0.08ENTER××+2ENTER0.5×0.5×0.5×0.14×0.08×+ 0.0093
ENTER enter (on the HP, puts the number on the stack)
Quick example
Variance 0.0093. √0.0093 = 9.64%. The weighted average of 14% and 8% would be 11%, so the mix is less risky than its parts.
- 0.0093√x 0.0964
√x square root
- 0.0093g√x 0.0964
g blue shift key · √x square root
Quick example
Weights 0.5, 0.3, 0.2. Variances (%²) 400, 100, 225; covariances 60 (1,2), 90 (1,3), 30 (2,3). Own terms 100 + 9 + 9 = 118; cross terms 2 × (9 + 9 + 1.8) = 39.6. Variance 157.6 %², so σₚ = 12.55%.
- 0.5x²×400+(0.3x²×100)+(0.2x²×225)+(2×0.5×0.3×60)+(2×0.5×0.2×90)+(2×0.3×0.2×30)= 157.6
- √x 12.55
x² square · √x square root
- 0.5ENTER×400×0.3ENTER×100×+0.2ENTER×225×+2ENTER0.5×0.3×60×+2ENTER0.5×0.2×90×+2ENTER0.3×0.2×30×+ 157.6
- g√x 12.55
ENTER enter (on the HP, puts the number on the stack) · g blue shift key · √x square root
Quick example
Ten assets need 10 variances and 10 × 9 ÷ 2 = 45 distinct covariances.
- 10×9÷2= 45
- 10ENTER9×2÷ 45
ENTER enter (on the HP, puts the number on the stack)
How it is asked
-
Two-asset σ from a correlation
Weights 80/20, standard deviations 10% and 20%, correlation 0.5. Portfolio σ?
Variance = 0.0064 + 0.0016 + 0.0032 = 0.0112, so σ = 10.58%. Traps: 12.0% (weighted average), 8.94% (no cross term).
-
Correlation from a covariance
Covariance 0.006, standard deviations 20% and 12%. Correlation?
0.006 ÷ (0.20 × 0.12) = 0.25. Trap: 0.15 (÷ the first variance).
-
What does a lower correlation do?
Weights and standard deviations fixed, correlation falls. Effect?
Portfolio σ falls; expected return is unchanged.
-
How many covariances?
Eight assets. Distinct covariances (excluding variances)?
8 × 7 ÷ 2 = 28. Traps: 56 (counts both triangles), 64 (the whole matrix).
Exam traps
- Leaving out the 2w₁w₂Cov term. For the 60/40 mix with correlation 0.2 that gives 11.06% instead of 11.52%.
- Averaging the standard deviations (13.2% here). That is right only when the correlation is +1.
- Mixing units: a covariance in %² (21.6) used with variances in decimals (0.0324). Stay in decimals or stay in percent.
- Squaring the weights but forgetting the 2 in the cross term, or squaring the weights in the cross term.
- Thinking a lower correlation lowers expected return. It changes risk only.
- Comparing covariances across pairs. A bigger covariance can sit beside a lower correlation when the assets are more volatile.
Checkpoint
5 exam-style questions. About 90 seconds each.
1A portfolio is 50% in asset X (standard deviation 20%) and 50% in asset Y (standard deviation 12%). The covariance of their returns is 0.006. The portfolio standard deviation is closest to:
2For the same two assets (standard deviations 20% and 12%, covariance 0.006), the correlation of returns is closest to:
3Holding the weights and the individual standard deviations constant, a fall in the correlation between two assets will most likely:
4An analyst needs every distinct covariance (not counting variances) for a portfolio of 8 assets. The number of covariances is:
5A portfolio is 40% in asset X (expected return 10%), 35% in asset Y (6%) and 25% in asset Z (2%). The portfolio's expected return is closest to:
Key takeaways
- Expected return is a weighted average; risk is not.
- σₚ² = w₁²σ₁² + w₂²σ₂² + 2w₁w₂ρσ₁σ₂, and Cov = ρσ₁σ₂.
- Lower correlation means lower risk and the same expected return.
- With n assets there are n variances and n(n − 1)/2 distinct covariances, so covariances dominate big portfolios.
Quick example
Weights 0.5, 0.3 and 0.2 in assets expected to return 10%, 6% and 3%. 0.5 × 10 + 0.3 × 6 + 0.2 × 3 = 7.4%.
- 0.5×10+(0.3×6)+(0.2×3)= 7.4
- 0.5ENTER10×0.3ENTER6×+0.2ENTER3×+ 7.4
ENTER enter (on the HP, puts the number on the stack)
Quick example
Two equally likely periods. In the first, asset 1 is 3 above its mean and asset 2 is 2 above. In the second, they are 1 and 4 below. Cov = 0.5 × (3 × 2) + 0.5 × (−1 × −4) = 5 (%²). Positive: the returns sit on the same side of their means.
- 0.5×3×2+(0.5×1+|-×4+|-)= 5
+|- change sign
- 0.5ENTER3×2×0.5ENTER1CHS×4CHS×+ 5
ENTER enter (on the HP, puts the number on the stack) · CHS change sign
Quick example
Correlation 0.4, standard deviations 20% and 10%. 0.4 × 0.20 × 0.10 = 0.008.
- 0.4×0.2×0.1= 0.008
- 0.4ENTER0.2×0.1× 0.008
ENTER enter (on the HP, puts the number on the stack)
Quick example
Covariance 0.0108, standard deviations 24% and 15%. 0.0108 ÷ (0.24 × 0.15) = 0.30.
- 0.0108÷(0.24×0.15)= 0.3
- 0.0108ENTER0.24ENTER0.15×÷ 0.3
ENTER enter (on the HP, puts the number on the stack)
Quick example
50/50 mix, standard deviations 14% and 8%, correlation 0.5. 0.25 × 0.0196 + 0.25 × 0.0064 + 2 × 0.25 × 0.5 × 0.14 × 0.08 = 0.0049 + 0.0016 + 0.0028 = 0.0093.
- 0.5x²×0.14x²+(0.5x²×0.08x²)+(2×0.5×0.5×0.5×0.14×0.08)= 0.0093
x² square
- 0.5ENTER×0.14ENTER××0.5ENTER×0.08ENTER××+2ENTER0.5×0.5×0.5×0.14×0.08×+ 0.0093
ENTER enter (on the HP, puts the number on the stack)
Quick example
Variance 0.0093. √0.0093 = 9.64%. The weighted average of 14% and 8% would be 11%, so the mix is less risky than its parts.
- 0.0093√x 0.0964
√x square root
- 0.0093g√x 0.0964
g blue shift key · √x square root
Quick example
Weights 0.5, 0.3, 0.2. Variances (%²) 400, 100, 225; covariances 60 (1,2), 90 (1,3), 30 (2,3). Own terms 100 + 9 + 9 = 118; cross terms 2 × (9 + 9 + 1.8) = 39.6. Variance 157.6 %², so σₚ = 12.55%.
- 0.5x²×400+(0.3x²×100)+(0.2x²×225)+(2×0.5×0.3×60)+(2×0.5×0.2×90)+(2×0.3×0.2×30)= 157.6
- √x 12.55
x² square · √x square root
- 0.5ENTER×400×0.3ENTER×100×+0.2ENTER×225×+2ENTER0.5×0.3×60×+2ENTER0.5×0.2×90×+2ENTER0.3×0.2×30×+ 157.6
- g√x 12.55
ENTER enter (on the HP, puts the number on the stack) · g blue shift key · √x square root
Quick example
Ten assets need 10 variances and 10 × 9 ÷ 2 = 45 distinct covariances.
- 10×9÷2= 45
- 10ENTER9×2÷ 45
ENTER enter (on the HP, puts the number on the stack)
Questions about this lesson?
Where this comes back
- Covariance and correlation from a joint probability table Portfolio Mathematics
- Portfolio Risk and Return: Part I Portfolio Construction
Questions candidates ask
How do you calculate the standard deviation of a two-asset portfolio?
Square each weight and multiply by that asset's variance, add twice the product of both weights, the correlation and both standard deviations, then take the square root of the total. Skipping the cross term, or averaging the two standard deviations, are the usual wrong answers.
Why does lower correlation reduce portfolio risk?
When two assets do not move in step, one tends to rise while the other falls, so the swings partly cancel. In the formula, the cross term shrinks as correlation falls. Expected return is a plain weighted average, so it does not change.
What is the difference between covariance and correlation in a portfolio?
Both measure whether two returns move together. Covariance is in squared units and depends on how volatile the assets are. Correlation divides by both standard deviations, so it has no units and always lies between −1 and +1, which makes pairs comparable.
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