What Is a Minimum Variance Portfolio?

Woman looks over her investment strategy.
Photo:

JGI/Tom Grill / Getty Images

 

Definition

A minimum variance portfolio is an investing method that helps you maximize returns and minimize risk. It involves diversifying your holdings to reduce volatility, or such that investments that may be risky on their own balance each other out when held together.

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 parts.
  • R-squared is a statistical measure of how close an investment fund is to a given market benchmark, often an index.

Definitions and Examples of 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 measure of a security's price movement (ups and downs).

In this case, "volatility" means the same thing as "market risk." The greater the volatility (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 for a greater chance of slow but steady returns over time. Doing so may also help you avoid a massive loss at some point.

A minimum variance portfolio might contain a number of high-risk stocks, for example, but each from different sectors, or from differently sized companies, so that they do not correlate with one another.

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 a few volatile investments with low correlation to each other. For instance, you might invest in tech and apparel, which is a common scenario for building this kind of portfolio.

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

One common method for building a minimum variance portfolio is to use mutual fund categories that have a relatively low correlation with each other. This follows a core and satellite portfolio structure, such as the following hypothetical allocation:

  • 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 can be relatively volatile, but all four have a low correlation with each other. With the possible exception of the bond index fund, the combination of all four together has lower volatility than any one by itself.

Note

When you diversify a portfolio, you are seeking to reduce volatility. This is the basis of this type of portfolio.

How to Measure Correlation

It helps to know how to measure correlation when you build this type of portfolio. One way to do that is to watch a measure called "R-squared" or “R2."

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

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

Suppose you want to reduce the volatility of your portfolio and that you hold an S&P 500 index mutual fund. In that case, you would also want to hold other investments with a low R2. That way, if the S&P 500 were to start to drop, your low-R2 holdings could cushion the blow. They won't rise and fall based on what the S&P 500 does.

Note

One example of a minimum variance portfolio 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, but they have a very low correlation in terms of performance. That's the part that matters. 

Note

To use this tactic to its fullest extent, you can combine risky assets. You could still see 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 a history of volatile price fluctuations, and each has a low correlation to the others. Over time, their low R2 creates lower volatility, compared to a portfolio consisting exclusively of one of those three stock types.

Was this page helpful?
Sources
The Balance uses only high-quality sources, including peer-reviewed studies, to support the facts within our articles. Read our editorial process to learn more about how we fact-check and keep our content accurate, reliable, and trustworthy.
  1. Vanguard. "Bond Market." Accessed Nov. 9, 2021.

Related Articles