How to determine a minimum variance portfolio?

A minimum variance portfolio is an investing method that helps you minimize risk and maximize returns. This often involves diversifying the assets used in the investments.

Minimum Variance Portfolio: Definitions and Examples

The aim of having a minimum variance portfolio is to diminish the volatility arising out of singular investments. By volatility, we want to measure a security's price movement in the share markets.

It is a proven fact that the greater the volatility, the higher the market risk. So, in case someone wants to minimize risk, they should want to minimize the ups and downs. This means a greater chance of slow but continuous and steady returns over time. This may let one skip a massive loss at some point.

How Does a Minimum Variance Portfolio Work?

There are predominantly two ways to create a minimum variance portfolio. First, one can stick with low-volatility investments. Second, one can select a few volatile investments with low correlation to each other. For example, one can invest in automobiles and apparel as a minimum variance portfolio.

An easy and good way of forming a minimum variance portfolio is to use mutual fund categories that have a relatively low correlation with each other. For example −

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

In this example, the first three fund categories are volatile. But, all of the four have a low correlation to each other. Except for the bond index fund, the combination of all four together has lower volatility than anyone singularly.

How to Measure Correlation

One must know how to measure correlation while building a portfolio like the one given above. One way to do that is known as "R-squared" or “R2."

Most often, the R-squared is dependent upon the correlation of an asset to a major benchmark index, such as the S&P 500. For instance, if your investment's R2 relative to the S&P 500 is 0.95, it means 95% of its price movement is explained by movements in the S&P 500.

An excellent example of a minimum variance portfolio is one that contains stock as well as a bond mutual fund. When stock prices are going up, bond prices may be negative or flat. But, when stock prices are dropping, bond prices are often found to rise.

Stocks and bonds don't usually often move in opposite directions. But, they have a very low relative correlation regarding performance. That's what matters the most. To use this technique to its fullest gain, one can combine risky assets in the investment. The returns will still be more without taking too much risk.