A covariance is a measure of how two random variables will change when compared to one another. However, in a financial or investment context, covariance describes the returns on two different investments over time when compared to different variables. Typically, these assets are marketable securities in an investor's portfolio, such as stocks.
A positive covariance indicates that the returns on both investments tend to move in the same direction. An inverse or negative covariance, on the other hand, indicates that the returns will drift apart. As a result, when one rises, the other falls.
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Covariance can also be used to diversify the portfolio of an investor. To do so, a portfolio manager should seek investments with a negative covariance to one another. That is, when the return on one asset falls, the return on another (related) asset rises. Buying stocks with a negative covariance is an excellent way to reduce risk in a portfolio. The extreme peaks and valleys in stock performance can be expected to cancel each other out, resulting in a more consistent rate of return over time.