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.

 

  •   23 October 2019
  • 2
  •      
  •   

RELATED ARTICLES

Stars align for fixed income

Do Government bonds still have a role to play for Australian investors?

Passive investing has risks too

banner

Most viewed in recent weeks

Making sense of record high markets as the world catches fire

The post-World War Two economic system is unravelling, leading to huge shifts in currency, bond and commodity markets, yet stocks seem oblivious to the chaos. This looks to history as a guide for what’s next.

3 ways to fix Australia’s affordability crisis

Our cost-of-living pressures go beyond the RBA: surging house prices, excessive migration, and expanding government programs, including the NDIS, are fuelling inflation, demanding bold, structural solutions.

Is there a better way to reform the CGT discount?

The capital gains tax discount is under review, but debate should go beyond its size. Its original purpose, design flaws and distortions suggest Australia could adopt a better, more targeted approach.

How cutting the CGT discount could help rebalance housing market

A more rational taxation system that supports home ownership but discourages asset speculation could provide greater financial support to first home buyers.

Welcome to Firstlinks Edition 648 with weekend update

This is my last edition as Editor of Firstlinks. I’m moving onto a new role though the newsletter will remain in good hands until my permanent replacement is found.

  • 5 February 2026

It’s economic reality, not fear-based momentum, driving gold higher

Most commentary on gold's recent record highs focus on it being the product of fear or speculative momentum. That's ignoring the deeper structural drivers at play. 

Latest Updates

Property

The 5% deposit scheme is bad for homeowners and Australia

An ‘affordability’ scheme making the county more vulnerable to economic shocks and contributing to the deteriorating financial situation of everyday Australians.

Investment strategies

Is defensive the new offensive?

Relatively boring, unglamorous, defensive stocks like Kroger and Allstate have quietly outperformed gilded tech giants, offering steady growth, visibility, and resilient returns in a market captivated by AI and flashier industries.

Shares

How the RBA scores on its inflation goal

The Reserve Bank continues to face criticism from all sides. A reminder of the RBA's mandate and a review of their track record in maintaining price stability since the early 1990s.

Investment strategies

Levered credit: A late cycle ingredient for drawdown pain

As credit spreads normalised through 2025, yield‑hungry investors have turned to leverage for high returns, uncomfortably echoing pre‑GFC behaviours. Investors need to be careful to understand the true risk‑return trade‑off.

Planning

The more things change… longevity just goes on increasing

Australia needs a major shift in longevity awareness, attitudes and behaviour if, as a community, we are to reap the benefits of increasing longevity. Adopting a national strategy is well overdue.

Property

The improving outlook of Australian commercial real estate

The sector is positioned to benefit from defensive and resilient income streams supported by embedded rental increase opportunities. 

Property

Seize hidden opportunities among 50+ home buyer schemes in Australia

There is a laundry list of government schemes to help Australian's struggling with housing affordability. Savvy buyers should take advantage to break into the property market.

Sponsors

Alliances

© 2026 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.