What is Minimum Variance Portfolio?
Definition: Minimum variance portfolio refers to a type of portfolio structuring that focuses on minimizing risks in investment while maximizing the profit-making potential.
This type of investment portfolio features individual assets that each has some level of risk. However, then are hedged when put together and this helps to achieve the lowest attainable level of risk while offering significant returns.
In simpler terms, a minimum variance portfolio is a collection of investment assets that would be risky when traded individually but then when put in a portfolio that contains other risky assets; the level of risk is hedged. A minimum Variance portfolio aims to reduce the level of volatility in an investment.
Volatility, in this case, refers to the frequency of price movements that could either be up or down. Investors are usually interested in minimizing risk and so the approach means that they will minimize the volatility.
How to Create a Minimum Variance Portfolio
The first thing about building a portfolio is that an investor needs to look for multiple investment opportunities. In this case, remember that the focus is on investment opportunities that are of low volatility. The investor therefore needs to come up with a list of low-volatility investments or volatile investment opportunities with barely any correlation to each other. The latter is particularly popular among investors when it comes to creating a minimum variance portfolio.
Low correlation investments are best described as investments that are not similar so they do not perform the same especially if they are in the same economic environment or market. In other words, this is a diversification approach.
Bonds and mutual funds are good examples of minimum variance portfolios. Bond prices usually tend to be negative or flat when stock prices are on the rise but then the inverse happens where bond prices turn bullish when stock prices are bearish.
Minimum Portfolio Variance Formula Calculation
Calculating portfolio variance requires the use of standard deviations of every security within a portfolio and you also have to factor in the correlations of every security pair that is part of the portfolio. You therefore need to evaluate the correlation coefficients or covariance of the securities that constitute the portfolio. As noted earlier, investors usually focus on securities with low correlation and this means that they also have low portfolio variance.
You calculate portfolio variance by multiplying each security’s squared weight with its corresponding variance. You then add double the weighted average weight multiplied by each security pair’s covariance. Below is a better representation of the factors you consider when calculating portfolio variance.
- σ1= Asset 1’s standard deviation
- σ2 = Asset 2’s standard deviation
- w1 = Asset 1’s portfolio weight
- w2 = Asset 2’s portfolio weight
- cov(1,2) = the two assets’ covariance calculated as p(1,2)σ1σ2. p(1,2) represents the correlation coefficient of the two assets.
Examples
There are quite a number of mutual funds that represent some of the best minimum variance portfolio examples. Some of them include:
- 30% Bond Index Fund
- 10% Small-Cap Stock Fund
- 20% Emerging Markets Stock Fund
- 40% S&P 500 Index Fund
The last three are quite volatile but the common characteristic in all of them is that their correlation to each other is low. All the funds combined have lower volatility compared to each of them on an individual basis except for the bond index fund.
The minimum variance portfolio concept is best suited for investors that are looking for a diversified portfolio which will allow them to make decent returns with the minimum level of risk. It gets around the problem of investing in risky assets individually, thus providing a safer approach to those assets.