{"id":1916,"date":"2020-08-09T10:06:28","date_gmt":"2020-08-09T10:06:28","guid":{"rendered":"https:\/\/demo.wealthface.ca\/blog\/?p=1916"},"modified":"2022-05-24T06:57:08","modified_gmt":"2022-05-24T06:57:08","slug":"minimum-variance-portfolio","status":"publish","type":"post","link":"https:\/\/wealthface.com\/blog\/minimum-variance-portfolio\/","title":{"rendered":"Minimum Variance Portfolio: Important Things to Know"},"content":{"rendered":"\n        <div class=\"shortcode_ad_trade-commission\">\n        <div class=\"_medea\">\n                        <img src=\"https:\/\/wealthface.com\/blog\/wp-content\/themes\/wealthface-blog\/assets\/images\/premium-trade-subscription-modal-invest.png\"\n                             alt=\"\">\n                    <\/div>\n            <div class=\"_wrap\">\n                <div class=\"_grid\">\n                    <div class=\"_item _medea\">\n                        <img src=\"https:\/\/wealthface.com\/blog\/wp-content\/themes\/wealthface-blog\/assets\/images\/premium-trade-subscription-modal-invest.png\"\n                             alt=\"\">\n                    <\/div>\n                    <div class=\"_item _content\">\n                        <div class=\"_titleTop\">Regulated by FSRA & SEC<\/div>\n                        <div class=\"_title\">0% trading commission<\/div>\n                        <div class=\"_subtitle\">Get $50 for free<\/div>\n                        <ul class=\"_ul\">\n                            <li>Buy any stock with $1<\/li>\n                            <li>Access AI Analysis<\/li>\n                            <li>Monitor stock scoring<\/li>\n                            <li>Select portfolio strategies<\/li>\n                            <li>Access real market price<\/li>\n                        <\/ul>\n                        <div class=\"_btn\">\n                            <a data-title-dl=\"0% trading commission\"\n                               href=\"\"\n                               class=\"buttonClickDL btn\">Subscribe now<\/a>\n                        <\/div>\n                    <\/div>\n                <\/div>\n                <div class=\"_free-text\">\n                <a data-title-dl=\"Free Trial, Free Plan, Profitable strategies for Pro trading\"\n                   class=\"linkClickDL _a\" id=\"_a\"\n                   href=\"\">\n                    Free Trial, Free Plan, Profitable strategies for Pro trading\n                <\/a>\n                <\/div>\n            <\/div>\n        <\/div>\n    \n\n\n\n<p><a href=\"https:\/\/wealthface.com\/blog\/what-is-the-purpose-of-a-diversified-portfolio\/\">The importance of diversification<\/a>, <a href=\"https:\/\/wealthface.com\/asset-allocation\">asset allocation<\/a>, and portfolio construction can not be overstated. <\/p>\n\n\n\n<p>A buy and hold strategy of low-cost <a href=\"https:\/\/wealthface.com\/blog\/how-to-invest-in-index-funds\/\">index funds<\/a> (or <a href=\"https:\/\/wealthface.com\/blog\/best-high-dividend-etfs\/\">ETFs<\/a>) is generally superior to picking individual stocks (and a smarter way to build wealth). <\/p>\n\n\n\n<p>Throughout it all, you may have heard the term minimum variance portfolio tossed around. <\/p>\n\n\n\n<p><strong>What on earth is that?<\/strong><\/p>\n\n\n\n<p><strong>Minimum Variance Portfolio is the technical way of representing a low-risk portfolio. <\/strong><\/p>\n\n\n\n<p>It carries low volatility as it correlates to your expected return (you\u2019re not assuming greater risk than is necessary). <\/p>\n\n\n\n<p>Obviously, a one line description won\u2019t be enough to satisfy all doubts. <\/p>\n\n\n\n<p>In this post, we\u2019re going to talk about what a minimum variance portfolio is, examples of how to build one, and why it\u2019s a useful risk management tool.<\/p>\n\n\n\n<p><strong><a href=\"https:\/\/wealthface.com\/contact-us\">Contact Us Today &amp; We Will Help You To Create A High Return, Low Risk Diversified Portfolio.<\/a><\/strong><\/p>\n\n\n\n<h2 id=\"h-minimum-variance-portfolio-101-getting-started\">Minimum Variance Portfolio 101: Getting Started<\/h2>\n\n\n\n<h2 id=\"h-what-is-a-minimum-variance-portfolio\">What Is A Minimum Variance Portfolio?<\/h2>\n\n\n\n<p>A minimum variance portfolio holds individual, volatile securities that aren\u2019t correlated with one another. <\/p>\n\n\n\n<p>One security might be surging in value while another is plummeting, it doesn\u2019t matter. Because of their low correlation, the portfolio as a whole is viewed as less risky. <\/p>\n\n\n\n<p>But how?<\/p>\n\n\n\n<p><strong>Let\u2019s go deeper.<\/strong><\/p>\n\n\n\n<p>Any two investments with a low correlation to each other can form a minimum variance portfolio (e.g., stocks and bonds). <\/p>\n\n\n\n<p>Variance is a measurement of risk. There\u2019s a lot of math&#8217;s behind it but simply put:<\/p>\n\n\n\n<p>Variance measures the daily fluctuations of an investment. The more significant the change in price, the higher its variance, and more volatile. <\/p>\n\n\n\n<p>For example, bonds have a lower volatility than stocks and low variance. The standard deviation of an investment is the square root of the variance \u2013 both measure portfolio risk.<\/p>\n\n\n\n<p>When people talk about what a wild ride the stock market is, that\u2019s what they mean. <\/p>\n\n\n\n<p><strong>One day your stock is up 24%, the next it\u2019s down -5%.<\/strong><\/p>\n\n\n\n<p>However, if you take a snapshot of the Dow from 1900 through the present, you will notice that the market always goes up.<\/p>\n\n\n\n<p><strong>You May Like: <a href=\"https:\/\/demo.wealthface.ca\/blog\/how-to-build-a-stock-portfolio\/\">How to Build a Stock Portfolio: Crucial Tips That You Must Read<\/a><\/strong><\/p>\n\n\n\n<h2 id=\"h-what-is-correlation\">What is Correlation?<\/h2>\n\n\n\n<p>Correlation measures movements between investments. It\u2019s kind of like watching two people on a date. <\/p>\n\n\n\n<p>Sometimes, they\u2019re in sync, move in lockstep, and finish each other\u2019s sentences. Other times, well, let\u2019s just say it isn\u2019t like that at all.<\/p>\n\n\n\n<p>For example, if two assets are negatively correlated, they\u2019ll move in opposite directions, like a date gone bad.<\/p>\n\n\n\n<p>While you are trying to implement a <strong>minimum variance portfolio<\/strong>, you should look for investments with low to negative correlation. You should look for diversification across asset classes.<\/p>\n\n\n\n<h2 id=\"h-what-is-diversification\"><a href=\"https:\/\/wealthface.com\/blog\/what-is-the-purpose-of-a-diversified-portfolio\/\">What is Diversification<\/a>?<\/h2>\n\n\n\n<h3 id=\"h-harry-markowitz-modern-portfolio-theory-and-the-efficient-frontier\">Harry Markowitz, Modern Portfolio Theory, and the Efficient Frontier<\/h3>\n\n\n\n<p>Harry Markowitz\u2019s work in the <strong>1950s <\/strong>won him a <strong>Nobel Prize<\/strong> and has become a cornerstone for modern portfolio construction. Notable accolades include:<\/p>\n\n\n\n<ul><li>Nobel Prize recipient in Economics<\/li><li>During his doctoral days at the University of Chicago, Markowitz\u2019s Ph.D. dissertation helped him write his book <i>Portfolio Selection.<\/i><\/li><li>Designed a computer language at RAND Corporation<\/li><li>Hedge Fund Manager<\/li><li>Acorns Investment Committee Advisor<\/li><\/ul>\n\n\n\n<p>Henry Markowitz explained MPT as a rating of two measurements:<\/p>\n\n\n\n<ul><li><strong>Volatility<\/strong><\/li><li><strong>Expected return<\/strong><\/li><\/ul>\n\n\n\n<p>At its core, MPT seeks to lower portfolio volatility through diversification while increasing your return. As investors, that\u2019s the dream. <\/p>\n\n\n\n<p>According to the Modern portfolio theory, choosing asset classes with low to negative correlation such as stocks and bonds can lead to a reduction in portfolio variance.<\/p>\n\n\n\n<h2 id=\"h-the-efficient-frontier\">The Efficient Frontier<\/h2>\n\n\n\n<p>The Efficient Frontier is a graph that rates your portfolio\u2019s risk (x-axis) versus return (y-axis). It shows you the amount of profit you should expect from an assumed level of risk. <\/p>\n\n\n\n<p>It\u2019s not the risk factor of an individual stock that matters, it\u2019s actually how the stock affects the risk factor of your entire portfolio that determines whether you should invest or not. <\/p>\n\n\n\n<p><strong>Must Read: <a href=\"https:\/\/wealthface.com\/blog\/active-vs-passive-investing\/\">Active vs. Passive Investing: Which is best for your portfolio?<\/a><\/strong><\/p>\n\n\n\n<p>Not all portfolios operate as efficiently as they could, and not all investments are created equal.<\/p>\n\n\n\n<p>The reason behind that is the fact that there\u2019s only a certain amount of accepted risk you can take before your investment portfolio becomes sub-optimal (i.e., too much risk, not enough return).<\/p>\n\n\n\n<p>Portfolios landing to the right and below the efficient frontier are viewed as inferior because the expected return is too low for the level of risk taken.<\/p>\n\n\n\n<p><strong>In a nutshell, an efficient portfolio (or a portfolio falling on the efficient frontier) offers the best return you can expect for the degree of volatility you\u2019re taking on. <\/strong><\/p>\n\n\n\n<p>It\u2019s an outgrowth of MPT. Because there\u2019s an infinite number of security combinations producing varying levels of return, the efficient frontier represents the best of those combinations.<\/p>\n\n\n\n<p>One school of thought suggests investors pivot from an efficient portfolio to a minimum variance portfolio as they near retirement.<\/p>\n\n\n\n<p><a href=\"https:\/\/wealthface.com\/blog\/how-to-build-a-stock-portfolio\/\">Highly-diversified portfolios<\/a> tend to hold a place along the efficient frontier.<\/p>\n\n\n\n<h2 id=\"h-minimum-variance-portfolios-in-action\">Minimum Variance Portfolios In Action<\/h2>\n\n\n\n<p>Take this simple example: Imagine you\u2019ve got a single asset class. Let\u2019s say it\u2019s a stock in an emerging market index fund. <\/p>\n\n\n\n<p><strong>That index fund alone is highly volatile. 100% invested in emerging market stocks is a risky play.<\/strong><\/p>\n\n\n\n<p>But if you throw in small-cap, total international, and large-cap stocks, (split evenly four ways) you\u2019ve reduced your risk through diversification.<\/p>\n\n\n\n<p>For example, a small-cap and an international stock won\u2019t always move in sync with each other. If international goes down, the other three won\u2019t be as affected. <\/p>\n\n\n\n<p>You\u2019ve just added four volatile, low-correlated investments to your portfolio while lowering risk.<\/p>\n\n\n\n<p><strong>An alternative would be to hold a percentage of <a href=\"https:\/\/wealthface.com\/blog\/national-bonds-uae\/\">bonds in your portfolio<\/a>.<\/strong><\/p>\n\n\n\n<p>Remember, having investments with low correlation is the key ingredient to a <strong>Minimum Variance Portfolio (MVP). <\/strong><\/p>\n\n\n\n<p>However, when you turn your focus towards individual stocks within specific sectors and buy on margin, the strategy becomes extremely complicated. <\/p>\n\n\n\n<p>Individual investors, particularly beginners, will want to steer clear. However, if you are curious enough, let\u2019s find out more about it.<\/p>\n\n\n\n<h2 id=\"h-minimum-variance-and-risk-parity\">Minimum Variance and Risk Parity<\/h2>\n\n\n\n<p>Another way to maximize returns is through leverage. Rather than stuff your portfolio with risky assets, an alternative is to balance your portfolio with safer securities.<\/p>\n\n\n\n<p>Now, you have the option to borrow against your low volatility portfolio. This can help you maximize your returns with the help of Risk Parity. <\/p>\n\n\n\n<p><strong>Billionaire hedge fund investor and manager Ray Dalio coined the investment strategy at his firm, Bridgewater.<\/strong><\/p>\n\n\n\n<p>It says that riskier assets are overpriced with sub-par returns. In a nutshell, you\u2019re accepting higher volatility for less reward. <\/p>\n\n\n\n<p>It also means that safer assets will get you superior returns considering the lower level of risk assumed.<\/p>\n\n\n\n<p>You\u2019re borrowing against your portfolio and investing heavier in low-risk securities. <\/p>\n\n\n\n<p>When you increase your leverage in the minimum variance portfolio, your potential earnings can increase without the use of risky assets.<\/p>\n\n\n\n<h2 id=\"h-the-sharpe-ratio-a-risk-management-tool\">The Sharpe Ratio: A Risk Management Tool<\/h2>\n\n\n\n<h3 id=\"h-measuring-return-and-risk\">Measuring Return and Risk<\/h3>\n\n\n\n<p>It makes sense to start from a risk-based approach. Past performance doesn\u2019t guarantee future results. <\/p>\n\n\n\n<p>However, financial analysts still wanted to make sense of it all. Sharpe ratio is a way to combine an investment\u2019s risk and return into one statistic.<\/p>\n\n\n\n<p>We already know that the standard deviation is a way to measure portfolio volatility. <\/p>\n\n\n\n<p><strong>Then William Sharpe discovered a calculation that accounts for both risk and return, aptly named The Sharpe Ratio.<\/strong><\/p>\n\n\n\n<p>He\u2019s also a Nobel Prize recipient for his work in the creation of the capital asset pricing model (CAPM) which says there are two types of risk:<\/p>\n\n\n\n<ul><li>Systematic (Market) risk can\u2019t be diversified away (e.g., the day-to-day gyrations of stock prices due to interest rates, inflation, etc.)<\/li><li>Unsystematic (Specific) risk consists of factors unique to a particular company and can be diversified away (e.g., a company\u2019s CEO is charged with doctoring the books and goes out of business, natural disasters, labor strikes, etc.)<\/li><\/ul>\n\n\n\n<p><strong>Takeaway: Market risk can\u2019t be removed through diversification and is the type of risk investors are rewarded for.<\/strong><\/p>\n\n\n\n<h3 id=\"h-mathematical-explanation\">Mathematical Explanation<\/h3>\n\n\n\n<p>The Sharpe Ratio in action looks like this:<\/p>\n\n\n\n<p><strong>Risk&nbsp; \u2044&nbsp; Return<\/strong><\/p>\n\n\n\n<p>For example, if you have an investment with an expected return of .10 and a standard deviation of .30, you\u2019d have this:<\/p>\n\n\n\n<p><strong>.10\/.30 = .33<\/strong><\/p>\n\n\n\n<p>Now imagine there\u2019s a second investment with the same expected return of 10%, but a standard deviation of .50:<\/p>\n\n\n\n<p><strong>.10\/.50 = .20<\/strong><\/p>\n\n\n\n<p>The investment with the higher Sharpe Ratio wins because you\u2019re getting the same return for less risk. <\/p>\n\n\n\n<p>The fact that Sharpe Ratio is absolute and not relative to a benchmark makes it really special. <\/p>\n\n\n\n<p>It tells you how much risk you\u2019re shouldering for the return. <\/p>\n\n\n\n<p>To reduce the amount of risk associated with a reward, investments with higher Sharpe Ratios come really handy.<\/p>\n\n\n\n<h2 id=\"h-minimum-variance-portfolio-conclusion\">Minimum Variance Portfolio: Conclusion<\/h2>\n\n\n\n<p>Portfolio optimization gets complicated fast. While minimum variance portfolios are important, your asset allocation is what matters most. <\/p>\n\n\n\n<p>Constructing your portfolio with a few <strong>low-cost index funds (or ETFs)<\/strong> and embracing a buy and hold strategy will lead you to long-term wealth with fewer headaches. <\/p>\n\n\n\n<p>A lower risk investment portfolio thanks to diversification and low (or non) correlated securities, this is the essence of minimum variance.<\/p>\n\n\n\n<p><strong>Interesting read: <a href=\"https:\/\/wealthface.com\/blog\/what-is-a-factor-based-portfolio\/\">What is a Factor Based Portfolio?<\/a><\/strong><\/p>\n\n\n\n<p>Investors chasing higher returns through advanced strategies with little understanding usually run into trouble. Keep it simple. <\/p>\n\n\n\n<p>Invest within the basic asset classes that you know (stocks, bonds, cash etc.). <\/p>\n\n\n\n<p>You\u2019ll still have your minimum variance portfolio, just a simpler one. And the simpler solution is always best. <\/p>\n\n\n\n<p>But if you\u2019re ready to jump into the deep end of the pool, go for it! If done right, it can potentially enhance your returns.<\/p>\n","protected":false},"excerpt":{"rendered":"<p>The importance of diversification, asset allocation, and portfolio construction can not be overstated. A buy and hold strategy of low-cost index funds (or ETFs) is generally superior to picking individual stocks (and a smarter way to build wealth). Throughout it all, you may have heard the term minimum variance portfolio tossed around. What on earth [&hellip;]<\/p>\n","protected":false},"author":2,"featured_media":1917,"comment_status":"closed","ping_status":"open","sticky":false,"template":"","format":"standard","meta":[],"categories":[5],"tags":[],"yoast_head":"<!-- This site is optimized with the Yoast SEO Premium plugin v17.9 (Yoast SEO v19.2) - https:\/\/yoast.com\/wordpress\/plugins\/seo\/ -->\n<title>Minimum Variance Portfolio: Important Things to Know - Wealthface<\/title>\n<meta name=\"description\" content=\"Minimum Variance Portfolio is the technical way of representing a low-risk portfolio. 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