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

The growing debt burden of retiring Australians

More Australians are retiring with larger mortgages and less super. This paper explores how unlocking housing wealth can help ease the nation’s growing retirement cashflow crunch.

Four best-ever charts for every adviser and investor

In any year since 1875, if you'd invested in the ASX, turned away and come back eight years later, your average return would be 120% with no negative periods. It's just one of the must-have stats that all investors should know.

Retirement income expectations hit new highs

Younger Australians think they’ll need $100k a year in retirement - nearly double what current retirees spend. Expectations are rising fast, but are they realistic or just another case of lifestyle inflation?

Why super returns may be heading lower

Five mega trends point to risks of a more inflation prone and lower growth environment. This, along with rich market valuations, should constrain medium term superannuation returns to around 5% per annum.

Preparing for aged care

Whether for yourself or a family member, it’s never too early to start thinking about aged care. This looks at the best ways to plan ahead, as well as the changes coming to aged care from November 1 this year.

Our experts on Jim Chalmers' super tax backdown

Labor has caved to pressure on key parts of the Division 296 tax, though also added some important nuances. Here are six experts’ views on the changes and what they mean for you.        

Latest Updates

Investment strategies

LICs vs ETFs – which perform best?

With investor sentiment shifting and ETFs surging ahead, we pit Australia’s biggest LICs against their ETF rivals to see which delivers better returns over the short and long term. The results are revealing.

Retirement

The growing debt burden of retiring Australians

More Australians are retiring with larger mortgages and less super. This paper explores how unlocking housing wealth can help ease the nation’s growing retirement cashflow crunch.

The ASX is full of broken blue chips

Investing in the ASX 20 or 200 requires vigilance. Blue chips aren’t immune to failure, and the old belief that you can simply hold them forever is outdated. 

Shares

Buying Guzman y Gomez, and not just for the burritos

Adding high-quality compounders at attractive valuations is difficult in an efficient market. However, during the volatile FY25 reporting season, an opportunity arose to increase a position in Mexican fast-food chain GYG.

Investment strategies

Factor investing and how to use ETFs to your advantage

Factor-based ETFs are bridging the gap between active and passive investing, giving investors low-cost access to proven drivers of long-term returns such as quality, value, momentum and dividend yield. 

Strategy

Engineers vs lawyers: the US-China divide that will shape this century

In Breakneck, Dan Wang contrasts China’s “engineering state” with America’s “lawyerly society,” showing how these mindsets drive innovation, dysfunction, and reshape global power amid rising rivalry. 

Retirement

18 rules for ageing well

The rules to age successfully include, 'the unexamined life lasts longer', 'change no more than one-eighth of your life at a time', 'nobody is thinking about you', and 'pursue virtue but don’t sweat it'.

Sponsors

Alliances

© 2025 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.