Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 329

Managing risk using asset diversification

Employing a strategic asset allocation (SAA) can minimise the overall level of portfolio risk for a given level of return. The investment strategy sets target weights to the asset classes in a portfolio. Weightings are primarily allocated based on the investment objective, time horizon and, most importantly, the risk tolerance of the investor.

Combining uncorrelated assets

Support for SAA is provided by the fundamental benefit of portfolio diversification. Combining a group of assets that are less than perfectly correlated can reduce the overall risk of a portfolio for a required rate of return. The main theory, known as Modern Portfolio Theory, was pioneered by Harry Markowitz for which he was later awarded a Nobel Prize (for Graham Hand's interviews with Mr Markowitz, see here and here).

It is centered on the notion that the return of an asset should not be viewed in isolation but assessed on its contribution to the overall portfolio risk and return. The portfolios that provide the highest return for a defined level of risk fall on what is called the efficient frontier. This combination of assets is deemed to have greater diversification and be less susceptible to nonsystematic risk.

To illustrate the risk and return benefits of a SAA in a portfolio, 10 year back-tested data has been provided for three portfolios with different risk profiles: Conservative, Balanced and High Growth.

The portfolio asset weightings have been based on the corresponding BetaShares ETF Model Portfolios of the same risk profiles. This example is provided for information purposes only and is not intended to reflect the actual performance of the model portfolios they have been based on. Risk profiles of each model portfolio are produced in accordance with the Australian Prudential Regulation Authority’s (APRA) standard risk measure.

In Figure 2, we have calculated the performance over a period of 10 years ending 30 September 2019, with monthly rebalancing back to the target SAA weights. Broad market cap weighted total return indices are used to generate asset class returns, focusing on indices that are commonly tracked by ETFs.

Figure 2 illustrates that each of the portfolios can be seen as ‘optimal portfolios’ that broadly fall on the efficient frontier. Compared to a portfolio of solely Australian Equity, the ‘High Growth’ portfolio provided a higher 10-year return and lower risk whilst having a monthly return correlation of 92.4%.

A 100% weighting towards Australian Equity would have been a sub-optimal portfolio and an inefficient investment strategy over the 10 years. This highlights the importance of asset diversification in a portfolio and the long-term risk versus return benefits it can provide.

Correlations in returns between different asset classes are also relevant in building a portfolio. Figure 3 shows a 10-year correlation matrix, including the blended portfolios described above. It's notable that even a 'balanced' portfolio has a high correlation to equities.

The results also show the higher returns come with greater 'risk', measured by the standard deviation. These are the classic trade offs expected under Modern Portfolio Theory.

 

Will Gormly is an ETF/LIC Specialist at Bell Potter Securities. This article is for general information only and does not consider the circumstances of any investor.

Firstlinks provides regular reports on LICs trading at discounts and premiums in the Education Centre.

 

RELATED ARTICLES

Diversification lessons from the GFC

Diversification: past, present and future

banner

Most viewed in recent weeks

Super changes, the Budget and 2021 versus 2022

Josh Frydenberg's third budget contained changes to superannuation and other rules but their effective date is expected to be 1 July 2022. Take care not to confuse them with changes due on 1 July 2021.

Noel's share winners and loser plus budget reality check

Among the share success stories is a poor personal experience as Telstra's service needs improving. Plus why the new budget announcements on downsizing and buying a home don't deserve the super hype.

Grantham interview on the coming day of reckoning

Jeremy Grantham has seen it all before, with bubbles every 15 years or so. The higher you go, the longer and greater the fall. You can have a high-priced asset or a high-yielding asset, but not both at the same time.

Whoyagonnacall? 10 unspoken risks buying off-the-plan

All new apartment buildings have defects, and inexperienced owners assume someone else will fix them. But developers and builders will not volunteer to spend time and money unless someone fights them. Part 1

Buffett says stock picking is too hard for most investors

Warren Buffett explained why he believes most investors should not pick stocks but simply own an S&P 500 index fund. "There's a lot more to picking stocks than figuring out what’s going to be a wonderful industry."

Should investors brace for uncomfortably high inflation?

The global recession came quickly and deeply but it has given way to a strong rebound. What are the lessons for investors, how should a portfolio change and what role will inflation play?

Latest Updates

Exchange traded products

ETFs are the Marvel of listed galaxies, even with star WAR

Until 2018, LICs and LITs dominated ETFs, much like the Star Wars franchise was the most lucrative in the world until Marvel came along. Now ETFs are double their rivals, just as Marvel conquered Star Wars.

Shares

Four leading tech stocks now look cheap

There are few opportunities to buy tech heavyweights at attractive prices. In Morningstar’s view, four global leaders are trading at decent discounts to their fair values, indicating potential for upside.

Shares

Why copper prices are at all-time highs

Known as Dr Copper for the uncanny way its price anticipates future economic activity, copper has hit all-time highs. What are the forces at play and strategies to benefit from the electric metal’s strength?

Economy

Baby bust: will infertility shape Australia's future?

In 1961, Australian women had 3.5 children on average but by 2018, this figure stood at just 1.7. Falling fertility creates a shift in demographics and the ratio of retirees to working-age people.

SMSF strategies

The Ultimate SMSF EOFY Checklist 2021

The end of FY2021 means rules and regulations to check for members of public super funds and SMSFs. Take advantage of opportunities but also avoid a knock on the door. Here are 25 items to check.

Economy

How long will the bad inflation news last?

The answer to whether the US inflation increase will prove temporary or permanent depends on the rates of growth of the quantity of money. It needs to be brought down to about 0.3% a month, and that's a problem.

Economy

The ‘cosmic’ forces leading the US to Modern Monetary Theory

If the world’s largest economy adopted a true MMT framework, the investment implications would be enormous. Economic growth would be materially greater but inflation and interest rates would also be much higher.

Sponsors

Alliances

© 2021 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. Any general advice or ‘regulated financial advice’ under New Zealand law has been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892) and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. For more information refer to our Financial Services Guide (AU) and Financial Advice Provider Disclosure Statement (NZ). You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.

Website Development by Master Publisher.