Minimum Variance Portfolio Definition and Examples

Learn How Correlation Can Affect Your Portfolio's Risk Level

Woman looks over her investment strategy.
•••

JGI/Tom Grill / Getty Images

 

A “minimum variance portfolio” may sound complex, but this method of building your portfolio can help you reach the ultimate goal of the smartest and most successful investors: maximize returns and minimize risk.

Best of all, it's not difficult to apply the method when you know how it works.

What Is a Minimum Variance Portfolio?

A minimum variance portfolio is a collection of securities that combine to minimize the price volatility of the overall portfolio. Volatility is a statistical measure of a particular security's price movement (ups and downs).

An investment’s volatility is interchangeable in meaning with “market risk”. Therefore, the greater the volatility of an investment (the wider the swings up and down in price), the higher the market risk. So, if you want to minimize risk, you want to minimize the ups and downs.

Creating a Minimum Variance Portfolio

To build a minimum variance portfolio, you need to stick with low-volatility investments or a combination of volatile investments with low correlation to each other. The latter portfolio is a common scenario for building a minimum variance portfolio.

Investments that have low correlation are those that perform differently compared to the prevailing market and economic environment. The strategy is a great example of diversification.

When you diversify a portfolio, you are essentially seeking to reduce volatility. This is the basis of the minimum variance portfolio.

How to Identify Correlation

It helps to understand how to measure correlation when you build a minimum variance portfolio.

One way to do that is to pay attention to a specific statistical measure called R-squared or “R2".

Most often, the R-squared is based upon correlation of a particular investment to a major benchmark index like the S&P 500.

For example, if your investment's R2 relative to the S&P 500 is 0.97, it means 97% of its price movement (ups and downs in performance) is explained by movements in the S&P 500.

To reduce the volatility of a portfolio, an investor holding an S&P 500 index mutual fund would want to hold additional investments with a low R2. That way, if the S&P 500 starts to drop, your low-R2 holdings could cushion the blow since they don’t rise and fall based on what the S&P 500 does.

Examples of Minimum Variance Portfolios

Stocks and Bonds

An example of a minimum variance portfolio one that holds a stock mutual fund and a bond mutual fund.

When stock prices are rising, bond prices may be flat to slightly negative; whereas, when stock prices are falling, bond prices are often rising.

Stocks and bonds don't often move in opposite directions, though. However, they have a very low correlation in terms of performance, and that’s what matters. 

Using the minimum variance portfolio strategy to its fullest extent, you can combine risky assets or investment types together and still achieve high relative returns without taking a high relative risk.

A good overall example of a minimum variance portfolio would be using mutual fund categories that have a relatively low correlation with each other. This particular example follows the core and satellite portfolio structure:

  • 40% S&P 500 index fund
  • 20% emerging markets stock fund
  • 10% small-cap stock fund
  • 30% bond index fund

The first three fund categories are relatively volatile, but all four have a relatively low correlation to each other. With the exception of the bond index fund, the combination of all four together has lower volatility than any one by itself.

Only Stocks

If you aren’t interested in funds, you may consider U.S. large-cap stocks, U.S. small-cap stocks, and emerging markets stocks.

Each of these have high relative risk and histories of volatile price fluctuations. They each have relatively low correlation to each other, too. Over time, their low R2 creates lower volatility compared to a portfolio consisting of 100% of only one of those three stock types.

The Bottom Line

In summary, a minimum variance portfolio can hold investment types that are volatile on their own but, when combined, create a diversified portfolio that has lower volatility than any of the individual parts.

The optimal minimum variance portfolio will decrease overall volatility with each investment added to it, even if the individual investments are volatile in nature.

Disclaimer: The information on this site is provided for discussion purposes only, and should not be misconstrued as investment advice. Under no circumstances does this information represent a recommendation to buy or sell securities.

Article Sources

  1. Morningstar. "R-squared." Accessed March 12, 2020.

  2. Vanguard. "Bond Market." Accessed March 12, 2020.