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Coefficient Variation - Anil Sir

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125 views5 pages

Coefficient Variation - Anil Sir

Uploaded by

Alamgir Hossain
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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What is the Coefficient of Variation?

The coefficient of variation (relative standard deviation) is a statistical measure of the


dispersion of data points around the mean. The metric is commonly used to compare
the data dispersion between distinct series of data. Unlike the standard deviation that
must always be considered in the context of the mean of the data, the coefficient of
variation provides a relatively simple and quick tool to compare different data series.

In finance, the coefficient of variation is important in investment selection. From a


financial perspective, the financial metric represents the risk-to-reward ratio where the
volatility shows the risk of an investment and the mean indicates the reward of an
investment.

By determining the coefficient of variation of different securities, an investor identifies


the risk-to-reward ratio of each security and develops an investment decision. Generally,
an investor seeks a security with a lower coefficient (of variation) because it provides
the most optimal risk-to-reward ratio with low volatility but high returns. However, the
low coefficient is not favorable when the average expected return is below zero.

Formula for Coefficient of Variation

Mathematically, the standard formula for the coefficient of variation is expressed in the
following way:

Where:

 σ – the standard deviation


 μ – the mean
 

In the context of finance, we can re-write the above formula in the following way:

Example of Coefficient of Variation

Fred wants to find a new investment for his portfolio. He is looking for a safe
investment that provides stable returns. He considers the following options for
investment:

 Stocks: Fred was offered stock of ABC Corp. It is a mature company with strong
operational and financial performance. The volatility of the stock is 10% and the
expected return is 14%.
 ETFs: Another option is an Exchange-Traded Fund (ETF) which tracks the performance
of the S&P 500 index. The ETF offers an expected return of 13% with a volatility of 7%.
 Bonds: Bonds with excellent credit ratings offer an expected return of 3% with 2%
volatility.

In order to select the most suitable investment opportunity, Fred decided to calculate
the coefficient of variation of each option. Using the formula above, he obtained the
following results:

 
 

Based on the calculations above, Fred wants to invest in the ETF because it offers the
lowest coefficient (of variation) with the most optimal risk-to-reward ratio.

Related Readings

CFI offers the Financial Modeling & Valuation Analyst (FMVA)™ certification program for
those looking to take their careers to the next level. To keep learning and advancing
your career, the following CFI resources will be helpful:

 Investing: A Beginner’s Guide


 Index Funds
 Portfolio Manager
 Systemic Risk
What is the Coefficient of Variation?

The coefficient of variation (CV) is a measure of relative variability. It is the ratio of the standard deviation to
the mean (average). For example, the expression “The standard deviation is 15% of the mean” is a CV.
The CV is particularly useful when you want to compare results from two different surveys or tests that
have different measures or values. For example, if you are comparing the results from two tests that have
different scoring mechanisms. If sample A has a CV of 12% and sample B has a CV of 25%, you would
say that sample B has more variation, relative to its mean.

Formula
The formula for the coefficient of variation is:
Coefficient of Variation = (Standard Deviation / Mean) * 100.
In symbols: CV = (SD/ ) * 100.
Multiplying the coefficient by 100 is an optional step to get a percentage, as opposed to a decimal

Coefficient of Variation Example


A researcher is comparing two multiple-choice tests with different conditions. In the first test, a typical
multiple-choice test is administered. In the second test, alternative choices (i.e. incorrect answers) are
randomly assigned to test takers. The results from the two tests are:

Regular Test Randomized Answers

Mean 59.9 44.8

SD 10.2 12.7

Trying to compare the two test results is challenging. Comparing standard deviations doesn’t really work,
because the means are also different. Calculation using the formula CV=(SD/Mean)*100 helps to make
sense of the data:
Regular Test Randomized Answers

Mean 59.9 44.8

SD 10.2 12.7

CV 17.03 28.35

Looking at the standard deviations of 10.2 and 12.7, you might think that the tests have similar results.
However, when you adjust for the difference in the means, the results have more significance:
Regular test: CV = 17.03
Randomized answers: CV = 28.35

The coefficient of variation can also be used to compare variability between different measures. For
example, you can compare IQ scores to scores on the Woodcock-Johnson III Tests of Cognitive Abilities.

Note: The Coefficient of Variation should only be used to compare positive data on a ratio scale. The CV
has little or no meaning for measurements on an interval scale. Examples of interval scales include
temperatures in Celsius or Fahrenheit, while the Kelvin scale is a ratio scale that starts at zero and
cannot, by definition, take on a negative value (0 degrees Kelvin is the absence of heat).

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