What Is a Minimum Variance Portfolio?

Minimum Variance Portfolio Explained

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A minimum variance portfolio is an investing method that helps you maximize returns and minimize risk. This involves diversifying your investments.

Learn how to choose the right securities to build such a portfolio.

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. This leads to a greater likelihood of slow-but-steady returns over time without a massive loss at any point.

How a Minimum Variance Portfolio Works

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, such as technology and apparel. 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.

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.

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

How to Measure 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, such as lthe S&P 500.

So 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.

An example of a minimum variance portfolio is one that holds a stock mutual fund as well as a bond mutual fund.

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

Stocks and bonds don't often move in opposite directions. 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.

Using This Strategy in 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 has 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.

Key Takeaways

  • A minimum variance portfolio is one that maximizes performance while minimizing risk.
  • It can hold investment types that are volatile on their own, but when combined, create a diversified portfolio with lower volatility than any of the individual parts.
  • A portfolio that combines a stock mutual fund and a bond mutual fund is an example.
  • The strategy is simple to implement.