Definition: The coefficient of variation, or CV, is a statistical measurement that shows how a set of data points is distributed around the mean of the set. In other words, a set of data is graphed and the CV equation is used to measure the variation in points from each other and the mean. Basically, it shows how regular or irregular a data pattern is.
What Does Coefficient of Variation Mean?
The coefficient of variation formula is calculated by dividing the standard deviation or volatility of an investment by the expected return.
Applying this concept to business, investors can chart out stock prices or company performance figures to see if there is a regular trend and how far each point is away from the mean point.
Basically, investors use this to measure the dispersion of events in order to assess and evaluate risk and volatility of a company or investment. Specifically, it is used to measure the relative risk among different stocks or investments throughout a portfolio, helping manage the overall level of risk. Portfolio managers simply divide the volatility of a stock, such as a public stock’s Beta value, by the investment’s expected return. This will help them estimate the future volatility of a stock and decide whether or not to include it in the portfolio.
Let’s look at an example.
Let’s use the scenario of an investor who wants a minimize risk as much as possible. This investor picks among a selection of three investments. He wants to see which offers the best reward relative to risk since he knows that the more risk an investor takes on, the more potential reward.
He considers one investment in Amazon, one that tracks the S&P 500 index, and a US treasury bond. Let’s assume the following:
Expected return: 10%
S&P 500 index
Expected return: 10%
US Treasury bond
Expected return: 3%
Thus, the CV of Amazon, S&P 500, and the US Treasury Bond are 2, 1, and 0.33 respectively. Thus, the investor would choose the Treasury bond, since it offers the lowest volatility for its return and minimizes risk the best out of the three investments.