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Two Approaches to Building a Low-Risk Portfolio

Every financial advisor knows the market is constantly changing and no two market cycles are identical. Each cycle varies in timespan, volatility and returns. Due to the unpredictability of the market, it is crucial to adopt a strategy with the ability to perform well in various conditions.

While it is impossible to construct a portfolio that is completely risk-free, there are two main approaches an investor may utilize when constructing an equity portfolio that will help them manage their risk exposure. Building a portfolio consisting of low-risk assets is achieved primarily by using either one of the principal low-volatility strategies—minimum variance approach and rankings or factor based approach—or a mixture of the two.

Minimum Variance Approach Provides Lowest Risk to Investors

Building a minimum variance portfolio (MVP) gives investors the lowest risk equity portfolio possible. Also known as the mean-variance optimized approach, this strategy was developed by Harry Markowitz in a 1952 study. The approach is incorporated into what is considered to be one of the most influential investment models—the modern portfolio theory.

The minimum variance approach emphasizes constructing a portfolio involving assets that have little to no correlation with one another. Lower correlation refers to how holdings perform relative to one another. A minimum variance portfolio is created by determining an investor’s risk level and calculating the combination of assets that creates the portfolio with the lowest risk, as measured by its standard deviation, for a given return. This measure of risk/return is demonstrated on Markowitz’s efficient frontier, a graph displaying the greatest return for each risk level; a minimum variance portfolio will sit on the farthest left corner of the frontier because of the lower risk involved. (For more from this author, see: 6 Risks Threatening Your Portfolio Today.)

Rankings or Factor Based Approach

The second principal method of assembling a low-volatility portfolio is the rankings- or factor-based approach. A rankings-based construction strategy may use a variety of tactics or factors to determine how assets will be ranked. Some ranking strategies utilize beta or alpha factors to create a tiered portfolio, but the most commonly used ranking measure is based on universal volatility—the given "universe" dependent on the decided market or sector. After determining the rankings based on the chosen criteria, a percentage of the least volatile holdings are taken, and a portfolio that is weighted by the measure of an asset’s standard deviation, from lowest to highest, is created.

However, this one-dimensional analysis may leave an investor’s portfolio vulnerable to other risk factors due to exposure bias and the failure to factor in other influences. In some cases, the rankings are not properly estimated because they do not take into consideration covariance between holdings and often neglect assets that lack available data.

Those who properly utilize low-volatility strategies may end up with a portfolio that tends to have a volatility reduction of 25% to 35% and a beta between 0.7 and 0.8. Regardless of the chosen approach, each strategy leaves investors with a portfolio defined by the characteristics of its lower risk assets.

(For more from this author, see: An Investment Strategy for Market Volatility.)