What is Variance Analysis?
Variance analysis, also known as risk analysis, is a method of analyzing the returns of an investment portfolio. The objective is to determine how much the investment portfolio’s return may vary from its expected value.
How can a Firm benefit from our Variance Analysis Freelance Experts?
In finance, an investment manager can generate a return on investment by buying assets and holding them for a long period of time. In the short term, the return will reflect the underlying market’s performance, but over time it will also ride upon risk factors such as inflation or interest rates. Variance analysis is a technique that allows an investor to measure this potential return around a given level of risk. Variance analysis is widely used in investing and has been shown to provide insights into which asset classes are more risky than others as well as identify those with greater quality from those with lower quality. Variance analysis measures how far actual results vary from budgetary projections i.e., the difference between our expectation and the reality. The purpose of variance analysis is to help managers pinpoint the areas where they need to make changes, and it informs them how much of a budget item they can spend. Without variance analysis, managers may not be able to spot where they can make improvements, and they will be left wondering if their planned budget is appropriate.
Variance analysis can also be used to compare two or more investments for risk level, duration, and expected return. Risk-adjusted returns are used to show how the returns of various investments compare with each other on a risk basis. This article provides readers with information about variance analysis as well as insight into the different approaches used by investors in managing portfolio risk. Risk can be measured statistically by measuring the difference between a portfolio’s excess return and its excess deviation from the mean. If the portfolio’s excess return is equal to its riskless rate, then the portfolio’s excess deviation (known as its variance and standard deviation) will equal zero. If the portfolio’s excess return is above its riskless rate, then the excess deviation will be less than zero.
The variance of a portfolio consisting of two assets is given as:
How do our team of Variance Analysis Experts carry out their analysis?
Variance analysis can be carried out using one or more of these methods:
- Graphical Variance Analysis
- Manually calculated variance analysis
- Spreadsheet-based variance analysis
- Automated variance analysis software.
How Fintalent’s Freelance Consultants help minimize Variance by reducing Portfolio Risks
Fintalent, a home to the best Market Evaluation experts, M&A, fintech experts, as well as venture capital consultants can help minimize variance by constructing investment portfolios in various ways in order to minimize risk and guarantee returns. The techniques used to manage these portfolios vary greatly and are classified as being either active, passive, or tactical management/market timing approaches.
Passive Portfolio Management: Passive management of portfolios is becoming increasingly popular, especially with the advent of new products, such as exchange-traded funds (ETFs). The passive approach to portfolio management relies on the underlying performance of an asset class rather than actively managing the portfolio by buying and selling assets. Passive portfolio managers attempt to replicate market performance by choosing asset classes that move in the same direction as the market. For example, if stocks are performing very well, then an investor may wish to hold more stocks in their portfolio. This is known as skimming the cream off of an asset class. The objective is to reduce the variability of a portfolio. Passive portfolio managers can also use a stock-trading rule, known as a stop order, to automatically sell a stock if it falls below a certain price. This is known as an automatic rebalancing strategy because it automatically reallocates assets as market values move. In this case, if an investor holds stocks that have fallen in value due to market conditions, the stop order will automatically sell those stocks and buy others that have appreciated instead. The advantage of passive management is that it produces good returns over time with very little effort from the investor. However, the downside is that returns can lag behind those of other asset classes.
Active Portfolio Management: Active portfolio management attempts to beat the market by actively trading assets. Investing is a positive-sum game, and as such, over the long term there is no way to consistently beat the market without taking on extra risk. Investing actively requires a high level of expertise and can be very time-consuming. It is rarely possible for investors to beat the market without taking on additional risk or deviating from standard asset allocation strategies. This often results in equity diversification not being achieved and increases overall portfolio risk. It also increases transaction costs and taxes, which can further reduce returns. Because of these issues, it is imperative that investors carefully examine each investment before committing capital to it. Although some investors may be able to beat the market, the vast majority of investors cannot. It is important for investors to remember that investments can go down as well as up, and attempting to time the market can be very costly.
Tactical Portfolio Management: Tactical portfolio management attempts to move in and out of asset classes based on market conditions. This approach involves switching between risky assets, such as stocks or bonds, and risk-free investments during periods of fear or greed in order to achieve above-average returns. If an investor believes that the equity markets are overvalued , then he may move his money into cash or bonds until stocks become cheaper. Many investors also use trend-tracking systems to buy and sell investments. Investors continually buy or sell based on patterns in the price of an index. For example, investors may buy an equity fund if the price of the index has moved upwards for 20 days in a row. The upside of this strategy is that it can prevent large losses by quickly moving money out of an asset class when it starts moving down in value. However, because this is based on past prices, it is impossible to predict whether this pattern will continue into the future. This approach can often produce large losses if investors jump into and out of the market too frequently.
Classes of Variances
There are identified classes of variance: favorable, unfavorable and zero. An unfavorable variance means that actual results are less favorable than projected results. A zero percent variance means that actual results are identical to targeted results or that actual results are not available yet. A favorable percentage means that actual results are more favorable than projected results.
Types of Variance Analysis
Budgeting Variance Analysis is a measure of the difference between actual and forecasted results, for a specific period.
For example, suppose you expect that your retail business will earn Rs. 20 crore for the year, and you have budgeted Rs. 15 crore. If actual results are Rs. 10 crore, then your budgeting variance is Rs. 5 crore (Rs. 10 – Rs. 15).
In direct proportion with the size of a business, its variance will grow in a big way in the initial stages of its development, so do not forget to calculate this number at each stage of your business life cycle. Although the method of calculating the variance is simple, it can be tricky to use it in real-time. This is because the result of one-time events is considered a part of the budgeting variance even though they do not affect your business operations.
For example, if you expect a profit on a particular project due to a one-time gain, and you actually realize it, you will need to calculate this amount as part of your budgeting variance.
Operating Variance Analysis analyses variance in business operations by comparing actual results with scheduled or forecasted results for inputs such as materials and labour.
The difference between scheduled or forecasted input value and actual input value is operating variance.
For example, if actual production hours are 5,000 hours and scheduled production hours are 4,500 hours, the operating variance is 500 hours.
Sales Variance Analysis analyses variance in business operations by comparing actual results with scheduled or forecasted results for inputs such as materials and labour.
The difference between scheduled or forecasted input value and actual input value is operating variance.
For example, if actual production hours are 5,000 hours and scheduled production hours are 4,500 hours, the operating variance is 500 hours.
Operating Variance Analysis analyses variance in business operations by comparing actual results with the expected results for inputs such as raw materials orders and employee compensation.
The difference between actual output value and expected output value is operating variance.
For example, if actual output is 100 units and the expected output is 200 units, then operating variance is 50 units.
Profit & Loss (P&L) Variance Analysis analyses the difference between actual profits net of taxes (or losses) and budgeted or targeted profits (or losses).
The difference between actual results for income statement items, expenses, gains / losses on sale of assets, etc. are P&L variances.
Research and Development (R&D) Variance Analysis analyses variance in business operations by comparing actual results with the expected results for specific R&D expenses.
The difference between actual output value and expected output value is operating variance.
For example, if actual output is 100 units and the expected output is 200 units, then operating variance is 50 units.
Taxable Interest expense Variance Analysis analyses variance in business operations by comparing actual results with budgeted or targeted tax rate on interest expense based on the balance sheet. The difference between actual interest expense and planned interest expense is the taxable interest expense variance.
Other identified types of variance analysis carried out by our team of experts include:
- Corporate general and administrative expenses (C&A expenses)
- Other operating expense (other operating expense)
- Unusual items (unusual items)
- Changes in fair value of financial instruments
- Changes in the fair value of assets and liabilities
- Changes in contingent consideration
- Changes in the fair value of embedded derivatives
- Interest income and capital gains related to investments, debt issues or distributions to unit holders, and other detailed categories of income and expenses that meet specific criteria defined by the company or are required by accounting regulations are reported as other operating activity, if they do not meet the criteria listed above. These are also classified as operating items if they are not one-time events.
Variance Analysis helps businesses find out the causes of variance in their operations which helps them take corrective measures to improve your business. By combining expert Variance Analysis offered by our team of consultants along with complementing service such as Profit and Loss Forecasting, Revenue Management, as well as Revenue analysis, businesses can take firm control of their income stream and revenue management.
