Covariance
A statistical measure of correlation of the fluctuations of two different quantities.
In finance, covariance is applied to the annual rates of return of different investments, to measure the correlation of their yeartoyear fluctuations in performance.
The definition is
Cov(r_{1}, r_{2}) = 1/n * (r_{1 i}  r_{1 ave}) * (r_{2 i}  r_{2 ave})
where the terms r_{1 i} and r_{2 i} are actual values of the annual rates of return of two investments, taken over several years,
n is the total number of values of r_{1 i} and r_{2 i} used,
and r_{1 ave} and r_{2 ave} are the average values of r_{1 i} and r_{2 i}.
See the article on the efficient frontier for a description of how covariance is related to asset allocation.
