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

Passive investing has risks too

Diversification lessons from the GFC

Diversification: past, present and future

banner

Most viewed in recent weeks

Are term deposits attractive right now?

If you’re like me, you may have put money into term deposits over the past year and it’s time to decide whether to roll them over or look elsewhere. Here are the pros and cons of cash versus other assets right now.

Uncomfortable truths: The real cost of living in retirement

How useful are the retirement savings and spending targets put out by various groups such as ASFA? Not very, and it's reducing the ability of ordinary retirees to fully understand their retirement income options.

Is Australia ready for its population growth over the next decade?

Australia will have 3.7 million more people in a decade's time, though the growth won't be evenly distributed. Over 85s will see the fastest growth, while the number of younger people will barely rise. 

How retiree spending plummets as we age

There's been little debate on how spending changes as people progress through retirement. Yet, it's a critical issue as it can have a significant impact on the level of savings required at the point of retirement.

20 US stocks to buy and hold forever

Recently, I compiled a list of ASX stocks that you could buy and hold forever. Here’s a follow-up list of US stocks that you could own indefinitely, including well-known names like Microsoft, as well as lesser-known gems.

The public servants demanding $3m super tax exemption

The $3 million super tax will capture retired, and soon to retire, public servants and politicians who are members of defined benefit superannuation schemes. Lobbying efforts for exemptions to the tax are intensifying.

Latest Updates

Property

Financial pathways to buying a home require planning

In the six months of my battle with brain cancer, one part of financial markets has fascinated me, and it’s probably not what you think. What's led the pages of my reading is real estate, especially residential.

Meg on SMSFs: $3 million super tax coming whether we’re ready or not

A Senate Committee reported back last week with a majority recommendation to pass the $3 million super tax unaltered. It seems that the tax is coming, and this is what those affected should be doing now to prepare for it.

Economy

Household spending falls as higher costs bite

Shoppers are cutting back spending at supermarkets, gyms, and bakeries to cope with soaring insurance and education costs as household spending continues to slump. Renters especially are feeling the pinch.

Shares

Who gets the gold stars this bank reporting season?

The recent bank reporting season saw all the major banks report solid results, large share buybacks, and very low bad debts. Here's a look at the main themes from the results, and the winners and losers.

Shares

Small caps v large caps: Don’t be penny wise but pound foolish

What is the catalyst for smalls caps to start outperforming their larger counterparts? Cheap relative valuation is bullish though it isn't a catalyst, so what else could drive a long-awaited turnaround?

Financial planning

Estate planning made simple, Part II

'Putting your affairs in order' is a term that is commonly used when people are approaching the end of their life. It is not as easy as it sounds, though it should not overwhelming, or consume all of your spare time.

Financial planning

Where Baby Boomer wealth will end up

By 2028, all Baby Boomers will be eligible for retirement and the Baby Boomer bubble will have all but deflated. Where will this generation's money end up, and what are the implications for the wealth management industry?

Sponsors

Alliances

© 2024 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. To the extent any content is general advice, it has been prepared for clients of Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), without reference to your financial objectives, situation or needs. For more information refer to our Financial Services Guide. 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.