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 fund20% emerging markets stock fund10% small-cap stock fund30% 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.
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. 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.
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.
