How this number is made
Two assets together are not as volatile as a weighted average of their volatilities, unless they move in lockstep. The gap is the correlation. The weight is the share in the first asset. The rest is the second. This is one period, one correlation, and no third position.
- Weight is a percent of the portfolio, not a dollar amount.
- A correlation of 1 is no diversification. A negative correlation cuts the mix further.
Formula
Variance = w²σ₁² + (1−w)²σ₂² + 2w(1−w)σ₁σ₂ρ. Volatility is the square root.
Worked example
With the figures already in the form, volatility of the mix is 10.42%.
Questions
What if the weights are not the dollars I hold?
Use market value, including a short as a negative weight. This form only allows a long mix: the second weight is whatever is left.
Does this include the cash I did not invest?
Only if you call cash the second asset and type its volatility, usually near zero.