- Diversification is a simple principle for reducing risk in an investment portfolio.
- It involves spreading your investments across a range of assets e.g. bonds, equities, cash.
- There’s a lot of data and possible outcomes to manage when it comes to comparing different assets classes and individual investments.
“Simple, but not easy” – Warren Buffett
That’s investing. The fundamental principles and goals of investing aren’t complicated: most of us are seeking to grow our wealth over the long-term at a rate that keeps us ahead of inflation, at the very least.
It’s the doing of it that’s complicated.
Finding where best to place your money across a diverse investing world is what we do. Understanding the true value of different investments, and any potential risks that could undermine returns, is challenging.
This quick guide to how we build portfolios explains why this process is so important to get the best outcomes for our investors.
Step 1: Understand the goals, limits and rules
All good portfolio construction begins by looking at investment goals and the amount of risk you’re prepared to tolerate to achieve those goals.
When people choose products simply because they have achieved high returns, they generally don’t pay attention to risks taken to deliver that performance. And it’s the short-term changes in asset values that are often seen as risks by new investors. News stories on the daily movements of companies and markets can create a lot of unhelpful distraction from the real risks involved in investing.
At Morningstar, we believe the real risk to be the permanent loss of a long-term investor’s savings. With this in mind, we look for under-priced assets to build our portfolios because they have less room to fall.
Step 2: Review asset classes, determine weightings
Diversification means spreading your investments over a range of assets that are exposed to different factors. It’s the gold standard for building investment portfolios because it can help with reducing risk. For example, equities, bonds, cash and currencies don’t usually perform identically. A fall in one type of asset in a portfolio can be offset by growth in others. Diversification won’t eliminate the potential for losing money, but it does act like a buffer if one investment takes a hit.
Research [i] has shown the weight given to each asset class – meaning the proportion of total money invested – is the single most important driver of long-term returns. It takes no small amount of time and effort to come up with the data and a framework for calculating those weightings.
Step 3: Compare risk/return profiles of assets
Given the dizzying array of potential investments, it’s important to have a clear and consistent framework to assess these opportunities. New technology makes it easier for companies like Morningstar to crunch global data to understand the fundamental drivers of an asset’s value. We rank around 350 global asset classes in total, according to their expected reward for risk. These include equity, bond and currency groups and subgroups, and we slice and dice these categories by country, quality, sector and region.
Step 4: Select assets and the proportion of capital to invest in each
There are multiple layers of diversification in a multi-asset portfolio. In addition to holding investments across asset classes and countries, we can also look for diversification within an asset class. With Australian shares, for example, a professionally managed portfolio will explore the potential value of shares in companies according to various industries and which countries their revenue comes from.
The Morningstar Next portfolios are also diversified by strategy. For each asset class, there are choices to be made between active management, or a passive or index exposure, and the fees that come with these choices also need to be considered.
Step 5: Explore how different situations can impact the portfolio
A portfolio may look diversified on paper, but you need to understand how each investment performs under different circumstances and how they perform relative to each other. We look at how a single investment can impact the expected return and risk for the portfolio. We analyse risk factors behind each investment so that returns from a portfolio are not dominated by a single risk factor. For example, corporate bonds and equities are from different asset classes, but at times, they can move in the same direction.
Step 6: Regular portfolio review
Diversification is an important goal for building a portfolio, but it isn’t a set and forget solution for managing risk and producing returns. Sound portfolio management means being prepared for a number of outcomes, not just one. At Morningstar, we’re constantly reviewing and monitoring our portfolios and this process is vital as financial markets carry significant levels of uncertainty.
We also keep monitoring the data on those 350 global asset class groups. This enables us to keep identifying new investment opportunities that can offer value so we can include them in our portfolios if they’re a good match for the overall risk/return outcome.
Building robust portfolios takes expertise, vigilance and – above all – time. Don’t get caught chasing the latest fund or sitting on the sidelines. Great financial outcomes are best avoided by taking a more patient, value-driven approach to choosing assets and investments.
Andrew Lill is Chief Investment Officer, Asia Pacific at Morningstar Investment Management.
© Morningstar Investment Management Australian Limited (‘Morningstar’) and any related bodies corporate that are involved in the document’s creation. Whilst all reasonable care has been taken to ensure the accuracy of information provided, neither Morningstar nor its third-party providers accept responsibility for any inaccuracy or for investment decisions by any person on the basis of the information included. Past performance is not a reliable indicator of future performance. Morningstar does not guarantee the performance of any investment. Any general advice has been prepared without reference to your investment objectives, financial situation or needs. You should consider the advice in light of these matters and if applicable, the relevant disclosure document before making any decision to invest. Refer to our Financial Services Guide for more information.
[i] Ibbotson, Roger G., Paul D. Kaplan. 2000. “Does Asset Allocation Policy Explain 40, 90, or 100 Percent of Performance?” Financial Analysts Journal, vol. 56, no. 1 (January/February):26–33.