The minimum variance portfolio is an investment method that helps you achieve the maximum possible return while minimizing risk. It involves diversifying your investments to reduce volatility, or balancing investments that may be risky on their own when held together.
Definition
A minimum variance portfolio is a collection of securities that come together to reduce the overall price volatility of the portfolio. Volatility is a measure of the price movement of a security (both upward and downward).
In this case, “volatility” means the same thing as “market risk.” The greater the volatility (the more price swings up and down), the higher the market risk. Therefore, if you want to reduce risk, you want to minimize volatility to increase the chances of a slow and steady return over time. This can also help you avoid massive losses at some point.
A minimum variance portfolio may contain a number of high-risk stocks, for example, but each from different sectors, or from companies of different sizes, so they are not correlated with each other.
How Does a Minimum Variance Portfolio Work?
To build a minimum variance portfolio, you can do one of two things. You can stick with low-volatility investments, or you can choose some volatile investments with low correlation among them. For example, you might invest in technology and clothing, which is a common scenario for building this type of portfolio.
Investments that have low correlation are those that perform differently compared to the market. This strategy is a great example of diversification.
One common way to construct a minimum variance portfolio is to use categories of mutual funds that have relatively low correlation with each other. This is followed by a core-and-satellite portfolio structure, such as the following default allocation:
- 40% S&P 500 Index Fund
- 20% Emerging Markets Stock Fund
- 10% Small-Cap Stock Fund
- 30% Bond Index Fund
The first three categories of funds may be relatively volatile, but the four together have low correlation with each other. Excluding the bond index fund, the combination of the four has lower volatility than any of them individually.
How to Measure Correlation
It is helpful to know how to measure correlation when building this type of portfolio. One way to do this is to monitor a measure called “R-squared.”
R-squared is often based on the correlation between an investment and a major market index, such as the S&P 500.
If the R2 of your specific investment compared to the S&P 500 is 0.97, then 97% of its price movement (the rises and falls in performance) is explained by movements in the S&P 500.
Suppose you want to reduce your portfolio’s volatility and you own an S&P 500 index fund. In that case, you would also want to invest in other investments with a low R2. This way, if the S&P 500 starts to decline, your low R2 investments can buffer the blow. They will not rise and fall based on what the S&P 500 is doing.
Another example of a minimum variance portfolio contains an equity fund and a bond fund. When stock prices rise, bond prices may be stable to slightly down, but when stock prices fall, bond prices often rise.
Stocks and bonds do not move in opposite directions very often, but they have very low correlation in performance. That’s the part that matters.
To maximize the benefit of this strategy, you can combine risky assets. This allows you to achieve relatively high returns without incurring relatively high risks.
Using This Strategy with Stocks
If you are not interested in funds, you can look into large-cap U.S. stocks, small-cap U.S. stocks, and emerging market stocks.
Each
One of these assets has relatively high risks and a history of volatile price fluctuations, each with a low correlation with the others. Over time, their low correlation leads to reduced volatility compared to a portfolio composed solely of one of these three assets.
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Sources:
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Vanguard. “Bond Market.” Accessed Nov. 9, 2021.
Source: https://www.thebalancemoney.com/minimum-variance-portfolio-overview-4155796
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