A statistical measure of how much the returns on two risky assets move together. In other words, it expresses the strength of correlation between two (or more) random variables. A positive covariance indicates that asset returns move in the same direction while a negative covariance implies that asset returns move in opposite directions. A zero value, however, plainly means no related movement in either direction exists.

This metric is usually calculated by finding the deviations of actual returns from expected returns. Statistically, covariance is often obtained by multiplying the correlation (between the two variables) by the standard deviation of each variable. When the two variables are identical, covariance becomes variance.

Portfolio diversification can virtually achieve its full potential when the returns of financial assets invested in don’t have a high covariance, or better yet when their covariance is negative.