06 Apr Minimum Variance Portfolio
What is Minimum Variance Portfolio?
Definition: A minimum variance portfolio is an investment portfolio that seeks to minimize the level of risk that the holder is exposed to. It does this by allocating sums to different financial securities and assets, which, when taken together, reduce the volatility of the portfolio.
What does Minimum Variance Portfolio mean?
A common investment objective is to maximize returns while keeping risk to a minimum. But that’s hard to achieve because, as a general rule, the investments that offer the chance of a higher return also carry a greater degree of risk.
A minimum variance portfolio offers a solution. It consists of different investments, which do not react in the same manner to external market developments.
How does that work? Say, you hold a portfolio of ten different stocks – Apple, Facebook, Netflix, Google, Amazon, NVIDIA, Microsoft, IBM, Alibaba, and Tesla. While it is true that you have diversified your portfolio, you could make large losses if the tech sector trends downwards. That’s because each of the companies that you have selected operates in the field of technology.
A better approach could be to invest in a minimum variance portfolio. This type of portfolio would be one, which, when considered in totality, exhibits a lower degree of volatility than each of its individual components.
Volatility refers to the change in prices of a financial security in response to various factors. A highly volatile stock can offer greater returns, but holding it could lead to bigger losses as well. So, instead of buying only tech stocks, it may be better to invest in a minimum variance portfolio that holds the shares of companies from different sectors.
A portfolio that includes banks, insurance firms, and car manufacturing companies in addition to tech stocks may provide relatively high returns while keeping the level of risk to a minimum.
Example of Minimum Variance Portfolio
Karl Schneider is an individual investor with a well-diversified stock portfolio. He holds shares in tech firms, banks and financial institutions, and traditional manufacturing companies as well. But he knows that if the stock market crashes, it could have a negative effect on all his stock holdings.
His financial advisor recommends that a certain part of the portfolio, say 5% to 10%, should be used to invest in gold. This advice is based on the following factors:
- Gold prices don’t move in tandem with stock prices. In fact, when the stock market crashes, gold valuations can rise. This can insulate Mr. Schneider’s portfolio from losses.
- At times of political and economic uncertainty, gold is seen as a safe haven asset. Stock prices can decline when the global economy slows. When this happens, investors flock to gold leading to an increase in valuations for the precious metal.
These two components (stocks and gold) can help Mr. Schneider construct a minimum variance portfolio. This has the potential to provide higher returns while controlling the level of risk.
A minimum variance portfolio contains assets that could be considered to be individually risky, but when taken together, they help to minimize the exposure to risk.