In part one of this article, I outlined the first three steps of the five-step process to create an investment strategy. An investment strategy reduces behavioural risk – the risk of bad decisions – and helps to align a goal to the individual investments that are purchased and sold in your portfolio.

Creating an investment strategy requires some time and thought but makes managing a portfolio significantly easier. As a reminder the steps needed to create an investment strategy are the following:

  1. Define your high level approach
  2. Set your asset allocation
  3. Determine your edge
  4. Identify security selection criteria
  5. Establish the basis for making changes to your portfolio


This article will cover step 4.

Part one can be found here

Part three can be found here

An example of an investment strategy

I’ve used my own investment strategy as an example to bring the process to life. My strategy is only applicable to my own circumstances. After going through the first three steps this is where I stand:

I will build passive income in my non-retirement accounts by 2035. To achieve my goal I will purchase income producing assets that provide a stable and growing income stream.

I will allocate 90% of my portfolio to growth assets and 10% to defensive assets.

My competitive advantage stems from behavioural and structural edge. Taking advantage of these sources of edge requires a focus on finding great dividend paying companies with long-term competitive advantages. I will purchase investments at attractive valuations and hold them for the long-term to take advantage of dividend growth. Structured decision making is the key to my success and to take advantage of my sources of edge.

Identify your security selection criteria

Investors are confronted with a vast array of choice. There are thousands of global publicly listed shares and ETFs. Australian investors can choose from 12k managed funds. Publicly listed companies range from giant multinationals to small locally focused businesses. ETFs and funds cover broad indexes and niche thematics. They follow countless investment strategies and can be actively and passively managed.

The abundance of choice creates challenges for investors. Some investors suffer from analysis paralysis and struggle to pull the trigger on an investment.

Ironically, knowing more about investing does not make this process any easier. People that are new to investing may feel overwhelmed by the seeming complexity of investment options. Experienced investors can feel equally overwhelmed by the potential flaws in each option. My colleague James Gruber wrote about these challenges when he tried to construct a simple 3 ETF portfolio.

Investors that make the leap and buy something can suffer buyer’s remorse and get tempted by alternate choices. This temptation is exacerbated by the fear of missing when faced with constant commentary on the merits of different strategies, markets and individual securities. This contributes to the constant churning of investor portfolios.

Defining your security selection criteria narrows the field and creates a more concentrated list of options. It also lessens the temptation to change investment approaches by maintaining the connection between a goal aligned investment strategy and portfolio holdings.

An investor may have different security selection criteria for different asset classes. This can be based on several factors. An example is that an investor may want to invest in individual companies for Australian shares given familiarity with the local market and the ease of trading. For emerging markets the same investor may want to use an ETF or fund because the markets are less familiar and it is very difficult to buy direct shares.

For new investors this step in an investment strategy may be challenging. It takes time and some knowledge to align a goal to the criteria used to select investments. More than anything it requires thinking. My suggestion is to get something on paper and refine it over time as you gain more experience and have a chance to clarify your thoughts.

Start with the types of investment vehicles given your sources of edge

Step three of defining an investment strategy involved identifying a source of edge or competitive advantage. If you found it challenging to articulate how you expected to do better than the average investor it might be a sign that you should get some help in managing your portfolio or stick to passive investing.

No edge means no individual shares. It means no thematic or factor ETFs. Just make sure you get exposure to the market or the part of the market that adheres to your investment approach and earn the average or index return. There is no shame in this approach. Focus on saving money and let the index do its job. This is a very effective approach to build wealth.

If you believe that you have informational or analytical edge it is worth considering where this plays out. Do you believe it will allow you to pick the right companies that provide you with the best opportunity to achieve your goals? The focus should be on purchasing individual shares.

Do you believe it allows you to identify asset classes or pockets of the market that are undervalued? That opens up the investment universe to individual shares and index tracking funds or ETFs. The key is simply directly funds into the attractive opportunities and avoiding unattractive parts of the market.

Do you believe you can pick the right managers that will enable you to achieve your goal? That means finding active fund and ETFs with talented managers.

It is worth noting once again that it is extremely difficult for any investor to maintain long-term informational and analytical edge.

If you believe you have behavioural or structural edge the key is discipline. Any type of investment can be used but making good decisions is paramount. Ensure that structures are in place to enable rational assessments of opportunities while eliminating or minimising emotional reactions to volatility.

My approach

Given the two sources of edge I identified I will invest in funds, ETFs and individual shares. However, I will avoid active funds and ETFs. My decision is to avoid active management in the portion of my portfolio aligned to my goal of generating passive income. To buy an active product is to outsource decision making without knowing what the manager is buying or selling or why thanks to Australia’s antiquated – and ridiculous – regulations that don’t force full disclosure of holdings.

Structural edge is something that impacts the average active manager which is one reason for high turnover. This is a generalisation. However, active managers also charge higher fees which detract from the income generated and generate poor tax outcomes when compared to passive products. This is also a generalisation. But without full disclosure of holdings it is very hard for me to find the managers that are adhering to my standards.

When combined with the fact that most active managers underperform it is enough for me to exclude active management. People may disagree with this decision. I’m ok with that as I don’t believe this decision impacts my ability to achieve my goals.

What personal circumstances influence investment selection

Personal circumstances play a role in transaction costs and tax implications. Everyone’s goal should be to minimise their impact on returns.

For super investors in the pension phase taxes can be ignored. Investors in lower marginal tax brackets or in super during the accumulation phase should be moderately concerned with minimising taxes. For investors with money outside of super in high marginal tax brackets minimising taxes is paramount.

Investor behaviour has an influence on returns. Holding investments for longer than a year is better than short-term holding periods. We will cover this in step 5.

The type of investment also matters. Both ETFs and Funds distribute capital gains to investors when they occur. In general, an actively managed ETF or fund will generate more capital gains than passive products. Some thematic or factor ETFs have high turnover due to rebalancing. It is important to understand how this works.

The advantage of holding individual shares is that the investor gets to choose when capital gains are realised. If you don’t sell you won’t pay capital gains taxes.

Transaction costs are dependent on an investor’s broker. Some brokers have low or no transaction costs. Transaction costs are also impacted by investor behaviour. Less trading means less transaction costs.

For an investor that is saving and investing continually with a high-cost broker transaction cost may play a role in the type of investment picked. Funds do not have transaction costs and savings plans may have lower investment limits.

My approach

I trade infrequently and have a low-cost broker. However, my income goal is for accounts that sit outside of super and I have to pay the marginal tax rate on capital gains and dividends. I can’t avoid taxes on income. But I do spend my income so this is just a cost of earning money. I want to avoid capital gains. This is another reason I want to avoid actively managed funds and ETFs and make sure that rebalancing policies are sensible. My individual share investments rarely generate capital gains given the low turnover of my portfolio.

The fact that I don’t trade a lot and have a low-cost broker means that transaction costs do not play a role in the vehicles I select.

Layer in the investment approach outlined in step one

This is where we start to incorporate your goals. If you are interested in generating and growing income than take an income tilt to whatever investment vehicle was previously identified. If you are looking for lower volatility than find investments that don’t tend to excessively fluctuate in price.

The more complicated part of this step is to identify the attributes that meet your approach.

This may take a bit of research. There are three common approaches that investors will have:

  • Meeting a specific return objective
  • Lower volatility
  • Income


I will outline the return objective approach and then use the income approach as my example.

Meeting a specific return objective is primarily an asset allocation decision. Higher returns require more of an allocation to growth assets. The asset allocation step went through this process. The key during the goal definition process is to make sure the return is achievable. If not, re-define your goal.

Don’t fall into the trap where you believe a specific investment approach will generate higher returns. There have been periods when growth has outperformed value. There have been periods when value has outperformed growth. Same thing with small caps vs. large caps, dividend paying shares vs. non-dividend paying shares and any other attribute.

At Morningstar we believe that the key attributes for long-term success are finding great companies with sustainable competitive advantages and companies trading below their intrinsic value. This matters a great day if you are picking individual shares. If not, you can either outsource the decision making to an active manager or simply dollar cost average into some form of ETF or fund that tracks an index.

My approach

I am interested in generating a sustainable and growing income stream. We can break down each of these components of my investment approach:

  1. Income: This is simple. I want investments that generate income. This eliminates anything that doesn’t generate income. The yield of my portfolio should be higher than the overall market. If not I would just buy the index.
  2. Sustainable: Sustainability of income is more complicated. But we can walk through some specific attributes. I don’t want a company whose earnings could fall significantly because they may not be able to maintain a dividend. That eliminates cyclical companies and companies that do not have moats and may succumb to competition over time. I want companies with medium or low Uncertainty Ratings. The Morningstar Uncertainty Rating assesses financial strength and business risk. Strong finances and low business risk are both positively correlated with a company’s ability to maintain dividends over time. I also want a lower payout rate which represents the amount of earnings paid out in dividends. I avoid excessively high payout rates that approach 100%. A high payout rate means that a drop in earnings could put the dividend in jeopardy as earnings may not be able to cover the payments to investors. I tend to buy larger companies that are well established with a diverse set of products and services. That provides more predictability of future outcomes.
  3. Growth: Companies with growing dividends also need to grow earnings. It is impossible to predict the future but moats or sustainable competitive advantages play a role here. Holding competition at bay gives the company the ability to protect market share.


Some of these attributes are conflicting. For example, it is hard to generate income at a higher rate than the market and also grow that income significantly. That isn’t a problem. I can create a mix of different investments in a portfolio. Some with high current income and some with higher potential for growth.

For fund and ETFs I’m avoiding actively managed products but fortunately my strategy is not unique. There are many factor ETFs and funds that track indexes that use rules to try and identify sustainable and growing dividends. Comparing the rules to my criteria allows me to assess the ETF or fund. I recently did this in an article looking at Australian dividend ETFs.


The first four steps of my investment strategy are complete. I have now defined my criteria for selecting investments. I will cover the last step in part 3 of this article.

In summary:

I will build passive income in my non-retirement accounts by 2035. To achieve my goal I will purchase income producing assets that provide a stable and growing income stream.
I will allocate 90% of my portfolio to growth assets and 10% to defensive assets.

My competitive advantage stems from behavioural and structural edge. Taking advantage of these sources of edge requires a focus on finding great dividend paying companies with long-term competitive advantages. I will purchase investments at attractive valuations and hold them for the long-term to take advantage of dividend growth. Structured decision making is the key to my success and to take advantage of my sources of edge.

I will invest in individual shares, ETFs and funds. I will avoid actively managed ETFs and funds and any that are likely to generate high levels of capital gains due to index construction and rebalancing policies.

I will invest in dividend paying shares and ETFs and funds that hold dividend paying shares.

I will focus on investments in high quality, non-cyclical companies with moats, strong finances, low business risk and acceptable payout ratios. My goal is for the yield of my overall portfolio to exceed the global market but more importantly I want growth in dividends so I will balance higher current dividend yields and income growth in individual holdings.