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Morningstar Guide to Selecting Investments

Shani Jayamanne  |  10 Sep 2020Text size  Decrease  Increase  |  
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At Morningstar we are proponents of the investor, and not the investment. This guide focuses on finding the right vehicles for you to achieve your goals, understanding which products and styles suit your objectives. If you have not set your goals yet, our Guide to Portfolio Construction will give you the requisite foundations to find the right assets for those goals.

Structuring your portfolio with the best vehicles to reach your goals often means considering more than one asset class, product or investment style. More products can, however, bring other considerations. How do I access them? What sort of upkeep will it entail? How much tax will I pay? If it’s this complex, why bother? And sure, you can invest in something because you’re familiar with it, but does this ensure it will achieve your goals? I am no stranger to this. During my time working at an asset manager my whole portfolio was in managed funds by the time I moved on to another job. I knew the product; I understood its intricacies and it suited my pay cheque-to-pay cheque approach to investing. And I saved on transaction costs. But once I sat down to understand whether these funds would help me achieve my goals, a different picture emerged. These funds may have had different names but many of them were investing in the same things. If I was to reach my goals I knew I needed to restructure and diversify my portfolio.

This guide will help you navigate your choices, and show you how to weigh up different asset classes and styles of investing to ensure you’re heading in the right direction.

Start with an Investment Policy Statement (IPS)

This statement provides the general investment goals and objectives and describes the strategies to help you get there. It can help you hold yourself accountable, and ensures you are being thoughtful and deliberate with your investing decisions.

An investment policy question connects your goals to the actual investments. In addition to specifying your goals, priorities and investment preferences, a well-conceived IPS ensures that you have a set review process that enables you to stay focused on the long-term objectives. This way, you can ignore short-term noise and avoid irrational decisions.

We’ve created an investment policy statement template you can use to document your strategy. You can tailor it to your circumstances and preferences. If you’re investing for multiple goals—retirement as well as a home, for example—it will probably make sense to create a separate one for each goal.

The following steps are required for your Investment Policy Statement.

Step 1: Document your goals.

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Documenting your goals might seem straightforward, but there’s more to this than meets the eye. Quantifying and prioritising your goals is paramount. If you do not quantify, you cannot measure success, and if you do not prioritise, you risk lack of focus hindering you from achieving any goals.

Quantifying how much you’ll need for retirement is particularly complex. You must forecast not just unknowables such as your life expectancy and rate of required return, but also factor in your own variables. How much will your spending change in retirement? Do you have non-portfolio sources of income such as a government pension?

There are many resources online to lean on, including life expectancy calculators, and required annual income for the type of lifestyle you would like to lead. Morningstar Investor has a ‘required rate of return calculator’ that you can use as part of documenting your goals.

Step 2: Outline your investment strategy.

The most successful investment strategies are straight-forward and succinct.

For instance, a strategy for those embarking on their investment journey may be as follows: ‘To invest primarily in low-cost passive investments, increasing contributions along with salary increases. Begin with 80% in aggressive assets, and transition to 50% in aggressive assets by retirement’.

An investment strategy for retirees might be: ‘To invest in dividend-paying equities and annuities to deliver a baseline of income; regularly rebalance to provide additional living expenses. Target a 50% defensive/50% aggressive mix.’

Step 3: Document current investments.

The next step is document all of your current investments with their recent values. For this, you may wish to use Morningstar Investor’s Portfolio Manager, which allows you to input these electronically and print out an appendix of investments through our affiliate Sharesight.

Step 4: Document target asset allocation

If you have not yet constructed your target asset allocation for your portfolio, you can use Morningstar’s Guide to Portfolio Construction to understand how target asset allocations work, and what suits your circumstances and goals.

Assets move in value—for your target asset allocations, they may be better expressed as ranges instead of a set figure to avoid over-rebalancing and incurring transaction costs. For example, you might have an 80% allocation towards equities, but on any given day that 80% could shift to 75% or 85% of your portfolio. Instead of 80%, express your equities asset allocation as 75%–85%. For major asset classes, stick to a range between 5–10%.

Step 5: Outline investment selection criteria.

In your Investment Policy Statement, you must outline your investment selection criteria that will provide guidelines for the types of investments that you want to hold.

For example, if you use Morningstar’s research in your investment decision-making process, you could specify that your equity holdings must have at least 3 stars, or your mutual funds must all be rated Bronze or better.

Step 6: Specify monitoring parameters.

Implicit in outlining all of the above policies—from asset allocation to investment-holding specifics—is that you’ll periodically check in on your portfolio to ensure it is still on track to reach your goals.

In this section, you will specify how often you will review your portfolio. Understand yourself, and what works for you—if checking too often will cause poor investor behaviour (such as panic buying or selling), set a less frequent period for review.

There may be a few layers to reviewing your portfolio.

It’s also crucial to understand whether your investments are still on track to meet your goals and whether they are diverging from your target asset allocation. You want to avoid over-trading, so you might want to rebalance only when major asset classes are a certain percentage point from the target. If you have set target ranges, this will make the process easier.

Only after these important points in a portfolio check-up, can you compare your portfolio’s performance to a benchmark with similar asset allocations.

Our Portfolio Manager has a toggle feature that can add and remove different benchmarks, including our asset allocation models that range from Conservative to Aggressive.

Types of Investments

Constructing your portfolio would have involved understanding your short-, medium- and long-term goals, and the asset allocation required for each. Short-term goals will require assets with liquidity and little to no volatility—most likely a cash product. Your medium- and long-term goals will require a mix of assets, with the ratios depending on how much risk you need to take to achieve your goals. The types of investments that you have in each bucket will vary, so this process of selecting investments must be repeated for each bucket.

If you have not gone through this process, visit our Guide to Portfolio Construction.

Now that you understand your objectives and what you need to achieve them, let’s look at the vehicles you can use to get to these goals.

There are a number of considerations to be made when deciding on the investments that make up your portfolio. The main questions to ask are:

1. Are you going to invest in individual securities or collective investment vehicles?

  • Individual securities are equities/stocks—they are an ownership stake in a company listed on a stock exchange.
  • Collective investment vehicles are professionally managed investments can be listed on an exchange (Exchange-Traded Funds and LICs) or unlisted (managed funds)

2. For collective investment vehicles are you going to employ an active or a passive strategy?

  • Active strategies involve picking assets that the manager thinks will help reach the goal of the fund (e.g. CPI + 2%, or to beat a benchmark that might be a market weighted index).
  • Passive strategies track a market weighted index or portfolio (e.g. ASX 200 – the top 200 companies on the ASX).

3. Are you going to focus on exchange-traded or non-exchange traded products?

  • An exchange-traded product is a product that is traded on the stock exchange. These include equities, Exchange-Traded Funds (ETFs) and LICs (Listed Investment Companies).
  • A non-exchange traded product is a product that is not listed, like a managed fund.

These decisions can be made by understanding the characteristics of investments, and whether they suit your circumstances as an investor. The answer may be that only one type of product may suit, or a combination of products and styles. We will explore the decision-making process for each of these questions, and the investment products that suit each outcome.

1. Are you going to invest in individual securities or collective investment vehicles?

The first step to choosing an investment is understanding whether individual securities or collective investment vehicles suit your circumstances.

There are benefits to both and investing in one does not mean that you are barred from considering the other. In most instances, both individual securities and collective investment vehicles have a place in an individual’s portfolio.

For this section, we can go through the some of the circumstances that may suit both types of investments, and how they may help you reach your financial goals.

Equities/Shares

When you purchase a share of a company, it makes you a partial owner of the business. That means that you own a portion of everything that the company has or does. This may take the form of tangible assets such as factories, equipment, real estate, cash and securities. Or intangible assets such as patents, trademarks, copyrights and brand names. As well as assets, buying a share also means that you may ‘own’ a portion of any liabilities a company may have. This may take the form of debt and other obligations a company has, including payments to suppliers, wages and taxes. The different between the company’s assets and liabilities is called the ‘book value’. The ‘book value per share’ represents what you are buying when you purchase a share.

However, investors do not purchase shares just for book value per share. What investors are buying is the future ability to generate cash. After all, a company is simply an organisational structure that is designed to take a group of people and a collection of assets and generate cash in perpetuity.

Why investors would invest in shares/equities

Investors all have circumstances and goals that are individual to them—once size does not fit all. Equities vary in region, sector, size (small/mid/large) cap and have a multiple of variables regarding their financial positions. Equities offer range and choice for investors, without the fees of professional management.

Apart from variety, investors should consider whether they have an investing edge that will offer them an advantage over professionally managed products. There are four main advantages that individual investors can have that may result in successful outcomes through equities investments: informational advantage, analytical advantage, structural advantage and behavioural advantage.

Informational advantages

An informational advantage means you know something about an investment that others don’t and which is therefore not priced into the equity. Although insider information is an advantage, we will exclude this as a consideration because it’s illegal. Legal informational advantages were more common when the investing community was exclusive and not as democratised. There has been progress towards democratisation through more securities regulation due to the work of individual investor advocates and wider access to information through the internet. It is extremely difficult now for investors to gain an informational edge. There are common anecdotes of cunning hedge funds hiring satellites to count the cars in shopping centre parking lots and digging deep into the supply chain of manufacturers to anticipate future sales results. Many of these examples show that it requires immense resources to gain an informational edge—not something most retail investors have. The rise in transparency and the democratisation of information has been hugely positive for the investing community, but it has also decreased the number of legal informational advantages that can be exploited.

It’s uncommon for individual investors to have an informational edge over professionals. Most professional managers have access to costly datasets and tools that are beyond the reach of individual investors. It is important to acknowledge that the internet has democratised access to information. The advantage that professionals have is mainly around how this information is structured and curated, which eases the ability to find relevant data.

Analytical advantages

Analytical edge refers to the ability to interpret widely available information in an insightful way. An analytical edge can manifest itself in many ways. It may take the form of a quantitative model that is better able to look at key security or economic metrics. Or it may simply be an individual that has deep knowledge of an industry and can better predict the impact of a company’s strategy, a legal or regulatory change or a business trend. At Morningstar, we are proponents of analytical edge and have developed a methodology based on three core principles: sustainable competitive advantage, valuation and margin of safety.

Structural advantages

Structural edge refers to the constructs that govern the way an investor goes about the investing process. These constructs around career progression, compensation and business goals can influence how professionals invest. Professional investors have competing priorities. They are trying to do things that support the company they work for and maximise their own compensation. Sometimes these two disparate influences align and induce wise investing decisions—sometimes they don’t.

This is one area that can be a real advantage for individual investors. Professionals certainly have some advantages over individual investors. Getting paid to do a job and charging other people for that job comes with standards around education and experience, support from other professionals, time to dedicate to the pursuit of investing and access to tools and data. It also comes with pressure to perform over short periods of time to maximise compensation and limit career risk. Here are some key areas where individual investors—provided they are patient and disciplined—can have a structural advantage over professionals:

  • A true focus on long-term investing: Every professional says that they are long-term investors. Yet many operate in an environment that structurally discourages this. Many professionals are under pressure to outpace or at least match their peers over one-year periods. If they fail, the investor money walks. This can cause closet indexing when active managers build portfolios that differ little from the underlying index and performance chasing where professionals are continually focused hot stocks and sectors. It also means that many professional investors lack the patience to wait for stocks trading at meaningful discounts to fair value or the patience to hold cheap and unloved shares long enough for them to approach fair value. In a study Morningstar conducted of US domestic equity funds, it was found that the turnover rate was ~63%. That means that the average holding period for stock in that fund was 19 months. This certainly does not meet the definition of long-term investing and the transaction costs and distributed capital gains can eat into investor gains. Professional investors know better than most why taking a long-term approach to investing is beneficial. Yet even with this knowledge, the pressure to maximise short-term performance to protect job security and renumeration has an outsized influence on the investing habits of many professionals. Individual investors don’t have any structural impediments to being long-term investors except their own lack of patience.
  • The ability to buy low and sell high: It is the most intuitive concept in investing. Buying when prices are low and selling when they are high. The structure of many funds makes this simple concept hard to execute. Past performance has an outsized influence on fund flows. Funds that have done well receive an abundance of new cash to invest while poorly performing funds are forced to sell securities to meet cash outflows. This can force even a well-meaning professional investor into doing the exact opposite of what you should be doing. Many professional investors don’t want to carry large cash balances since that will cause their portfolio to differ significantly from their associated index which, as previously mentioned, many are loath to do. In an effort to prevent cash balances from accumulating, funds will invest the incoming cash. In many cases, they are investing when the assets they hold are overpriced. The opposite occurs when investors withdraw funds after poor performance. Fund managers are forced to sell in order to generate cash to send back to investors. They are often selling at exactly the same time that assets are likely cheap. Individual investors do not have to worry about fund flows influencing their behaviour and can concentrate on the underlying value of the assets and their long-term goals.

Behavioural advantages

Behavioural edge is perhaps the most interesting and least understood investor advantage. It is grounded in the fact that humans are hard-wired to make poor investing decisions. We are driven by fear and greed, which is formula for buying at the top of the market and selling at the bottom. Both individual and professional investors create elaborate models and theories designed to dictate when and why to buy or sell a security. Despite these models there is still a high probability that an investor will panic when the market is going down and will succumb to the fear of missing out on riches when it keeps climbing. The Morningstar fair value estimate is designed to prevent these types of behavioural mistakes. Changes in security prices do not affect the fair value estimate but do change the Morningstar Analyst Rating, which is inversely affected by the price movement. In order to gain behavioural edge, the investor must internalise the notion that investing is more than a mathematical analysis of risk and return. Successful investing requires a struggle with ourselves to tune out irrelevant information, to have the strength to stick to the plan and resist the urge to follow the herd. This is where an IPS can really assist you, ensuring that you stick to your long-term strategy. Behaviour and patience may be the last real sources of sustainable edge for an individual investor. The ability to endure short-term discomfort and focus on long-time horizons is an enduring advantage that individuals have over professional investors.

This is another area that can be a real advantage for individual investors. This may sound counter-intuitive as professionals should understand the behavioural challenges faced by investors and have structures in place to alleviate behavioural challenges. Here are some key areas in which individual investors have behavioural advantages over professionals:

  • Going against the herd: It is hard to do better than average if you do the same thing as everyone else. All investors take comfort in the herd, but this can be exacerbated in professional settings. Many professional investors are reluctant to stray too far from conventional wisdom. From a reputational and career perspective it is often better to be wrong along with all of your peers than to take a chance and be different. Individual investors have more of an opportunity to be contrarian, which can be a successful strategy as it may lead to a focus on inexpensive assets.
  • Action bias: Professional investors spend all day investing. They are doing research, talking with their colleagues about investing ideas and focusing intently on financial markets. At first glance, this appears to be an advantage. After all, the professionals are typically better informed and more focused on their investment portfolio. However, the more time an investor spends focused on financial markets the greater the likelihood the investor will want to do something. As humans we have an action bias. When confronted with constant stimuli we want to do something because we think that will make things better. In investing that means that we believe that trading will improve returns. The problem is that trading too much can have the opposite result. Trading too much raises transaction costs and can lead to capital gains taxes. Individual investors have day jobs that are a distraction from the day-to-day movements of markets. These movements are often arbitrary and irrelevant to the long-term prospects of the underlying investments and the ability of investors to meet their goals.
  • Professionals certainly have some advantages over individual investors. Getting paid to do a job and charging other people for that job comes with standards around education and experience, support from other professionals, time to dedicate to the pursuit of investing and access to tools and data. It also comes with pressure to perform over short periods to maximise compensation and limit career risk.

Collective investment vehicles—including managed funds, ETFs and LICs

Pooling your cash with other investors may give you exposure to previously inaccessible opportunities and allows you to diversify your portfolio over potentially thousands of shares instead of individual equities.

table

*as at 2nd September 2020

Collective investment vehicles can offer investors a path to easy diversification and professional management.

Some collective vehicles are listed (ETFs and LICs) and others are unlisted (managed funds). Managed funds can offer attractive benefits to many investors that do not have large lump sums to invest. Most managed funds do not have transaction costs, which means that you are able to invest more often, and with smaller balances. This works well for investors who are setting aside funds from each pay cheque, or those that recognise that they are more comfortable with dollar-cost averaging (drip-feeding their funds in smaller instalments) than investing a lump sum.

Further along in this guide, we will speak about inefficiencies in the market, and the success of professional managers in certain sectors that experience inefficiencies because they are often under-researched or overlooked by institutional investors. If you are looking to invest in inefficient markets like emerging markets, or small- to mid-caps, professional managers can add value.

2. Collective investment vehicles: an active or passive strategy?

If you are investing in a collective investment vehicle, you must decide if you are going to employ an active strategy, or a passive strategy. An active strategy is when you outsource your funds to a professional manager who will invest the funds based on a particular strategy and investment style, looking to beat a benchmark set for the fund. A passive strategy is when a fund (exchange-traded or unlisted) tracks an index or portfolio—in other words, no stock-picking is occurring. However, it is worth noting that you do not need to exclusively use one or the other. You can be a proponent of both active and employ passive when constructing your portfolio.

To understand where each strategy might fit in your portfolio, consider the following questions:

How efficient is the underlying market?

The degree of efficiency pertains to how much the prices in that market reflect the underlying valuation. Now nobody knows how efficient a market is, so the question boils down to how often does an active manager outperform their designated index? This normally is a lot harder in markets where there is intense competition and widespread investor interest—for example, large-cap stocks. Andrew Miles, Manager Research Analyst at Morningstar, explains, “If you are investing in active funds that are looking mostly at large-cap stops like the ASX200, you’re going to find it difficult to achieve a return that overperforms the benchmark. These companies are heavily researched by institutions, fund managers, and brokers alike, so they are well understood. Lower down in the market, where there aren’t eyes on the companies and traditional brokers do not cover, there are opportunities for these companies to be misunderstood—that is where managers and individuals find attractive buys.”

Generally, less efficient markets are the markets that investors are less interested in and there are structural issues preventing investors from accessing them—small-caps are a good example. In the same breath, emerging markets are similar in that it is likely for companies within this asset class to be misunderstood. In countries such as China, there is a larger mix of retail investors that are momentum driven—ie who seek to capitalise on market trends. This gives investors opportunities but also presents risks.

This is supported by our Active-Passive Barometer report. Published half-yearly, it puts into context how active managers are performing against their benchmarks. Although US focused, the results reveal that in general, actively managed funds have failed to beat their benchmarks, especially over longer time horizons. Only 24% of all active funds topped the average of their passive rivals over the ten-year period ended June 2020. When we are looking at where the success lies, it was higher among international funds, real estate funds and bond funds. The lowest success rate was with large-cap US funds, which are extremely well researched and watched.

How large is the fee hurdle?

Fees are a large reason why many investors choose passive over active. The higher the fee, the harder it is for the manager to beat the benchmark. Fees can be extremely detrimental to investment performance and returns—if the fee hurdle is too large, it may be worth considering a passive alternative.

Tying into the efficiency of underlying markets, it is important to understand how much you are paying to access these markets, and whether efficient markets are worth consigning to active managers. It is not uncommon for active managers in Australia to charge between 0.8-1.5% as a management fee, with many failing to beat their designated benchmarks.

The Active-Passive Barometer report also reveals that price doesn’t always mean value—the cheapest active funds succeeded about twice as often as the priciest ones (34% success rate versus 16% success rate) over the 10-year period ended June 30, 2020. This not only reflects cost advantages and how it translates to performance, but also differences in survival, as 65% of the cheapest funds survived, whereas 49% of the most expensive did so.

Although fees shouldn’t be the deciding factor, it is very difficult for active managers to find opportunities in markets that are diligently watched. If you are looking to allocate your portfolio to large-cap stocks in developed markets like Australia, the US and the UK, historically, passive funds have been a better bet.

How representative is the index to the opportunities an active manager can access?

Active management is very hard in large US and some other developed market stocks. As mentioned, it is more successful in smaller markets, smaller-cap stocks and in fixed interest. For example, in a 10-year period to June 30, 2019—only 8% of large CAP US active managers beat their index. This compares to rates of over 50% for certain fixed interest and small-cap funds. The key is to compare the category average to the index. This will give an indication as to whether professional managers have opportunities on which to capitalise through active management.

How liquid are the underlying assets?

Index investing works best when underlying holdings are regularly traded at a high volume. Index managers are looking at low tracking error—in less liquid markets this is harder to do as buy/sell spreads are wider and the price of an asset may move away from the manager before they can build the position that they need. If you are looking at positions in asset classes that are not as liquid, it may be worth outsourcing to a professional manager. Passive investing may be more attractive in highly liquid markets such as equities.

3. Are you going to focus on exchange-traded or non-exchange traded products?

table

The table above shows a few key differences between the vehicles.

Transaction costs

Transaction costs can, if not managed, eat into your investment returns. Listed vehicles (Equities, ETFs and LICs) incur brokerage every time you buy or sell, so this must be a consideration for investors if you are either investing frequently, or if you are drawing down on your investments, such as in retirement.

If you are investing frequently—whether that be with every pay cheque, or you are breaking a lump sum into pieces to dollar-cost average (DCA), a managed fund may be a better option for you. If you are investing infrequently or in lump sums, it broadens your option to investments that incur brokerage.

Managed funds (unlisted): May suit lower balances and frequent additional investments

Equities, ETFs, LICs (listed): May suit lump sums

Management fees

Management fees make a large difference to your overall outcome. Generally, managed funds have higher fees because they have higher administration costs. This is due to overheads such as fund accounting teams and investment teams made of analysts and portfolio managers.

The graph below shows the detrimental impact of management fees. The impact of a 0.5% difference in fees on a $100,000 investment ($1,000 additional investments every month over 20 years, with 6% p.a. return) is over $47,000.

Results / impact of fees

chart

Source: MoneySmart. Assumptions: 6% p.a. return, $100,000 starting balance and $1,000 additional investment per month

However, this is not to say that you should choose the cheapest investment on the market. There are a few reasons why a higher management fee might still deserve a place in your portfolio.

One of the reasons why you might go for an unlisted investment with a higher management fee is to access markets that typically have high barriers of entry for individual investors, whether that be due to large minimum trades, the ability to transact in that market, or regulatory reasons. This could include credit, microcap and types of infrastructure.

Another reason why you might choose to pay a higher fee is if you do not have enough capital to build a diversified portfolio without prohibitive transaction costs. Studies show that 12 to 18 shares are required to diversify away 90% of the non-systemic (or individual company) risk in a portfolio. This is a situation where a collective investment vehicle might be right for you—a managed fund, ETF or LIC.

Ultimately, you must decide whether the management fee is earned, or if you are better off investing yourself by choosing individual investments. Do you believe that you have a competitive advantage that will help you reach your goals by purchasing individual securities rather than a collective investment vehicle? If not, should you invest in a listed or non-listed option? All things being equal, ETFs tend to have lower management fees, and if you are able to invest with an amount where brokerage makes sense and the investment makes sense, ETFs may be the right option for you. If you are after a specific active management strategy, LICs or Managed Funds may be right for you.

Managed funds (unlisted): Continued additional investments, specific strategies, access to professional management

Equities, ETFs and LICs (listed): Larger balances, if you have a competitive advantage picking individual securities

Trading flexibility

Trading flexibility is important to some investors who would like the option of buying or selling assets whenever they need. Managed funds are unlisted, and a unit price is struck each day. What this means is that you are not able to trade intra-day, as you are with ETFs, LICs and direct equities, all of which are listed.

Ultimately, trading flexibility should not be a significant consideration for long-term investors. Having flexibility to trade intra-day is not a priority over a long-time horizon.

Managed funds (unlisted): lower flexibility, prices once a day. Suitable for long-term investors.

Equities, ETFs and LICs (listed): higher flexibility to trade intra-day.

Minimum Investments

Minimum investments for listed vehicles are effectively non-existent—you are able to purchase one unit of a stock, ETF or LIC, and that will be the minimum to invest. However, this does not always make sense. As we spoke about in the section on transaction costs, brokerage can have a big impact on your investment returns. Being able to buy a share for $3 does not mean you should purchase one unit for $3 and pay $10 in brokerage. Therefore, logical minimums should be imposed to ensure the amount of units you are purchasing makes sense.

For unlisted assets – managed funds, minimum investments are decided by the manager. Minimum investments can differ greatly between providers, with some managed funds starting at $500, and others with $100,000 initial minimum investments. For lower minimum investments, you can access funds through platforms in Australia.

Managed funds (unlisted): Dependent on the provider. Starting from $500

Equities, ETFs and LICs (listed): No minimums, but important to ensure that the investment amount makes sense for the brokerage paid.

Behavioural risks

Behavioural risks reflect our tendency as humans to act emotionally during volatility. We are driven by fear and greed, which is formula for buying at the top of the market and selling at the bottom. Both

individual and professional investors create elaborate models and theories designed to dictate when and why to buy or sell a security. Despite these models there is still a high probability that an investor will panic when the market is going down and fear missing out on profits when it keeps climbing. These actions have been shown to be to the detriment of the returns an investor achieves. This is called the ‘behaviour gap’—the gap between an investment return and the return an investor gets in the same time period. Constantly switching between investments and assets due to emotional responses has been proven to reduce returns for the majority of investors.

 

behaviour gap graphic

Source: Carl Richards 

The Morningstar fair value estimate is designed to prevent these types of behavioural mistakes. Changes in security prices do not impact the fair value estimate but do change the Morningstar Analyst Rating, which is inversely impacted by the price movement.

Successful investing means blocking irrelevant information, and having the strength to stick to the plan and resist the urge to follow the herd. Some investments promote this, whilst others encourage overtrading. Managed funds have a higher barrier to trade—this is called a ‘speed bump’, which can encourage you to think twice before making a transaction. They price once a day, which means that you do not see intra-day volatility like you do with listed assets. Most managed funds also require paperwork to redeem assets, which acts as a physical speed bump, where investors may think twice about making a transaction because of the time and effort taken to make it.

Listed assets are a little different—these barriers are not as high and you are able to freely trade between market open and close.

Managed funds (unlisted): higher barriers to trade and priced once a day, protects against behavioural risks

Equities, ETFs and LICs (listed): priced during market open and close, little to no barrier to trade and protect against behavioural risks

How Morningstar Investor can help you with Selecting Investments

Image of the Portfolio X-ray

Portfolio X-Ray

Morningstar Portfolio X-Ray™ helps you understand at-a-glance the basic characteristics of a portfolio including its asset allocation, exposure to different investment styles, geographic regions and sectors.

Morningstar calculates numerous measures, based on an analysis of the full holdings of each fund within the portfolio, that help illustrate risk at both an individual fund and portfolio level. You can use the Portfolio X-Ray to understand your current asset allocation and the changes needed to meet a new allocation.

1. Asset Allocation

Many believe that asset allocation is the single most important determinant to overall portfolio performance, even more so than the selection of specific investments. Providing a true representation of the portfolio’s overall asset breakdown is key to helping you understand whether the portfolio is structured to help you reach your goals.

2. Stock Regions

This is a great way to quickly see in which regions your portfolio (or a specific fund) is invested. This will help prevent home bias or concentration risk and help with selecting collective investment vehicles for a particular allocation.

3. Stock Sectors

The Morningstar Sector Breakdown highlights exposure to defensive stocks (industries that are relatively safe and are likely not to be greatly impacted by market volatility), cyclicals (industries that do well in good times but tend to suffer in downturns) and sensitive stocks (stocks that although not immune to a bad economy, are less likely to be impacted than cyclicals). This could help a more cautious investor to look to expand their portfolios’ defensive exposure over their cyclical exposure.

4. Performance

Illustration of the portfolio performance compared to a benchmark, if available.

5. Morningstar Style Box

The Morningstar Style Box evaluates the style of the portfolio, such as growth or value and small, medium or large cap which can increase your understanding of the risk held in your portfolio.

6. Analyse the Overall Sector Exposure of a Portfolio

The Morningstar Portfolio X-Ray™ report provides in-depth numerical analysis—as well as a visual representation—of the portfolio’s overall sector exposure.

Discover investments

Morningstar provides qualitative research coverage on over 2,000 equities, ETFs, Funds and Hybrids alongside data on over 50,000 global securities. Discover investments is designed to allow you to find the investment opportunities that fit your needs.

Stock filter

Morningstar Investor provides access to a vast array of stock data and research that allows subscribers to Discover investments. We provide data on over 43,000 global equities. As a Investor subscriber you can access qualitative research from our global team of over 100 equity analysts on more than 1600 companies. For the remainder of our coverage universe we provide our proprietary quantitative ratings which are designed to mimic our analyst-driven ratings.

Our stock filters can be used by Morningstar Investor subscribers to comb through our comprehensive set of data and research to discover new investment opportunities. We have two sets of stock filters available:

Pre-defined filters: Our pre-defined filters identify companies that we believe are trading at a significant discount to what they are worth, have a long-term competitive advantage or meet the criteria for a thematic such as inclusion on our Global Equity Best ideas list or securities that generate sustainable income.

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User-defined filters: Select your own criteria to filter more than 43,000 global companies. You can select 15 filters across 5 categories including Morningstar analyst ratings, valuation and profitability measures, growth metrics and performance history. Filters can be saved to allow you to periodically check if additional companies meet your criteria. To set up and save a stock filter follow this link, select “Add filter”, select “Stocks”, select “Filters” and select your criteria. Selecting “Apply” will filter through our universe of equity data to identify the results. To save the filter simply select “Save” and add a name and description. Your filter will be available on the “Investment filters” tab

Fund filter

Morningstar Investor provides access to data and research on Australian domiciled funds. As an Investor subscriber you can access qualitative research from our team of Sydney-based manager research analysts on more than 350 managed funds.

Our Fund filters can be used by Morningstar Investor subscribers to comb through our comprehensive set of data and research to discover new investment opportunities. We have two sets of fund filters available:

Pre-defined filters: Our pre-defined filters identify funds that our analysts believe have the ability to outperform their peer group and/or relevant benchmark on a risk-adjusted basis over the long term. We have grouped the pre-defined filters by different asset classes.

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User-defined filters: Select your own criteria to filter through our universe of funds. You can select 15 filters across 5 categories including Morningstar analyst ratings, yield and cost and performance. Filters can be saved to allow you to periodically check if additional funds meet your criteria. To set up and save a stock filter follow this link, select “Add filter”, select “Funds”, select “Filters” and select your criteria. Selecting “Apply” will filter through our universe of fund data to identify the results. To save the filter simply select “Save” and add a name and description. Your filter will be available on the “Investment filters” tab.

ETF filter

Morningstar Investor provides access to data and research on ETFs. As an Investor subscriber you can access qualitative research from our team of manager research analysts on more than 70 ETFs.

Our ETF filters can be used by Morningstar Investor subscribers to comb through our comprehensive set of data and research to discover new investment opportunities. We have two sets of ETF filters available:

Pre-defined filters: Our pre-defined filters identify ETFs that our analysts believe have the ability to outperform their peer group and/or relevant benchmark on a risk-adjusted basis over the long term. We have grouped the pre-defined filters by different asset classes.

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User-defined filters: Select your own criteria to filter through our universe of ETFs. You can select 15 filters across 5 categories including Morningstar analyst ratings, yield and cost and performance. Filters can be saved to allow you to periodically check if additional funds meet your criteria. To set up and save a stock filter follow this link, select “Add filter”, select “ETFs”, select “Filters” and select your criteria. Selecting “Apply” will filter through our universe of ETF data to identify the results. To save the filter simply select “Save” and add a name and description. Your filter will be available on the “Investment filters” tab.

Watchlist

The watchlist is a tool that can be used to track stocks, ETFs and funds for further research. The watchlist can be used to observe price movements as you wait for a more compelling buying opportunity or to track Morningstar ratings, company profile information and performance. To add or remove a security from your watchlist, find the security in the discover investment tab or in the search box and click the heart icon.

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is an investment specialist, Individual Investor, Morningstar Australia.

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