Many investors start with choosing investments. For goals-based investing, it is the last step - and for a reason. It is important that your portfolio is built around your goals, and not around investments. Shani Jayamanne goes through how to select investments in your portfolio that align with the type of investor you are and your goals. 

Additional resources:

Article: Should I only invest in shares? Shares are high growth. If I want high growth, should I just invest in shares?

Guide: Guide to selecting investments 

Tool: IPS template 

Article: How to create an investment strategy

Podcast: Selecting investments to reach your goals available on Apple Podcasts, Spotify and Google Podcasts. 

Proceed to Module 7: How to set yourself up for investing success: Monitoring and Maintaining your portfolio

Setting up a portfolio is not the end of your work as an investor. The goalposts are always changing with markets, investments and circumstances. Mark LaMonica, CFA goes through the steps to monitor and maintain your portfolio so you are still on track to achieve your goals.

Back to course outline. 

Module transcript

Shani Jayamanne: Many investors ask the question, should I invest in a lump sum or should I dollar cost average? First, let's start with explaining what dollar cost average or DCA is. DCA is a strategy used to invest across multiple lots instead of a lump sum. The purpose of this strategy is to reduce the risk of investing in an unfavorable price. Realistically though, many of us invest paycheck to paycheck, which is similar to DCA. If you're an investor who has a lump sum to invest in the markets, that scenario would involve weighing up whether time in the market, so the amount of time that you spend works out better than investing in parcels. Morningstar has conducted studies on what has historically been the better choice, and lump sum investing has been favorable for most investors in most market conditions.

Investing with a lump sum meant there was more time for a large sum of money to grow and compound, and the price difference wasn't really that significant enough in equities and bonds to justify drip feeding those funds. However, this is also up to your temperament as an investor. If you're an investor who would feel more confident with spreading out risk, DCAing your amount may suit your temperament. The main goal is to get invested in the market and be comfortable with the decision that you make.

Let's speak a little bit about investing edge. 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. These edges are informational advantage, analytical advantage, structural advantage, or behavioral advantage. Let's start with informational advantage. Informational advantages means that 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're going to exclude that considering it's illegal. Legal informational advantages were more common when the investing community was exclusive and not as democratized. There's been progress towards democratization through more securities regulation due to the work of individual investor advocates.

And we've also got wider access to information through the internet. It's extremely difficult now for investors to gain an informational advantage. There are common anecdotes of cunning hedge funds hiring satellites to count the cars in shopping center parking lots and digging deeper into supply chains of manufacturers to anticipate future sales results. Many of these examples show that it requires immense resources to gain any informational edge, not something most retail investors can have. The rise in transparency and the democratization of information has been hugely positive for investing. It has also decreased the number of legal informational advantages that can be exploited. So it's uncommon for individual investors like us to have an informational edge over professionals.

Most professional managers have access to costly data sets and tools that are beyond the reach of individual investors. It's important to acknowledge that the internet has democratized access to investing and information for investors. But the advantage that professionals have is mainly around how this information is structured and curated, which eases the ability to find relevant data.

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

We'll move on to structural advantages now. A structural edge refers to the constructs that govern the way an investor goes about the investing process. And these constructs are around career progression, compensation, and business goals that can influence how professional investors invest. Professional investors have competing priorities. They're trying to do things that support the company that they work for, and they're also trying to maximize their own compensation. Sometimes these two disparate influencers align and they induce wise investing decisions, sometimes they don't. This is one area that can be a real advantage for individual investors.

Professionals certainly do have some advantages over individual investors. Getting paid to do a job and charging other people for that job comes with standards around the education and experience that they have, and the support that they get from other professionals and time to dedicate to the pursuit of investing. And they've got access to tools and data. It comes with pressure to perform over short periods of time as well, and this is to maximize their compensation and to limit their career risk. Here are some of the key areas where individual investors, provided that they are patient and disciplined, can have a structural edge over professionals.

The first is 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. What we see with professional investors is that they're constantly under pressure to outpace or at least match their peers over one year periods. If they don't do this, the investor money walks. This can cause something called closet indexing, where active managers build portfolios that defer very little from the underlying index and their performance chase where professionals are continuously focusing on really 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 these stocks for a long time.

In a study, Morningstar conducted a U.S. domestic equity funds. It was found that the turnover rate was around 63%. That means that the average holding period for stocks in that fund was 19 months. This certainly doesn't meet the definition of long-term investing and the transaction costs and distributed capital gains can eat into your returns as an investor. Professional investors know better than most why taking a long-term approach to investing is beneficial. Yet even with this knowledge, the pressure to maximize short-term performance to protect their job security and their remuneration has an outsized influence on the investing habits of many of these professional investors.

Individual investors like you and me don't have any structural impediments to being long-term investors except for our own lack of patience. One of the things that we're able to do is the ability to buy low and sell high. It's the most intuitive concept in investing. Buying when prices are low and selling when they're high. The structure of many funds makes this simple concept really hard for them to execute. Past performance has an outsized influence on fund flows, and funds that have done well receive an abundance of new cash to invest while poorly performing funds are forced to sell securities to meet these cash outflows, so all these withdrawals that investors are making.

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 (indiscernible) to do. In an effort to prevent cash balances from accumulating, funds will invest the incoming cash. In many cases, they're investing when the assets they hold are overpriced. The opposite occurs when investors withdraw their funds after poor performance. Fund managers are forced to sell in order to generate cash to send back to investors. They're often selling at the exact same time these assets are likely cheap. Individual investors do not have to worry about fund flows influencing their behavior, and they can concentrate on the underlying value of the assets and their long-term goals.

The next advantage is behavioral. Behavioral edge is perhaps the most interesting and the least understood investor advantage. It's grounded in the fact that humans were hardwired to make poor investing decisions. And the reason we're hardwired to make poor investing decisions is because we're driven by fear and greed, which is the formula for buying at the top of the market and selling at the bottom. Both individuals and professional investors create elaborate models and theories designed to dictate when and why to buy or sell a security. Despite these models, there's still a high probability that an investor will panic when the market is going down, and they'll succumb to the fear of missing out on riches when it keeps climbing.

We have the Morningstar fair value estimate, and that's designed to prevent these types of behavioral mistakes. Changes in security prices do not affect the fair value estimate, but they do change the Morningstar analyst rating, which is inversely affected by the price movement. In order to gain behavioral edge, the investor must internalize 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 in ensuring that you stick to your long-term strategy. Behavior 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-term 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 counterintuitive, as professionals should understand the behavioral challenges faced by investors and have the structures in place to alleviate behavioral challenges, but here are some key areas in which individual investors have behavioral advantages over professional investors. The first is going against the herd.

It's 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. What we see is that many professional investors are reluctant to stray too far from conventional wisdom. From a reputational and career perspective, it's 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 a contrarian, which can be a successful strategy as it may lead to a focus on inexpensive assets.

We also have action bias. Professional investors spend all day investing, they're doing research, they're talking with their colleagues about investing, and they're 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 focusing on financial markets, the greater the likelihood the investor will do something. As humans, we have an action bias. When confronted with constant stimuli, we want to do something because we think it'll 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 results.

Trading too much raises transaction costs and can lead to capital gains taxes. Individual investors like you and me, we have day jobs that are a distraction from the day-to-day movements of the markets. These movements are often arbitrary and they're irrelevant to the long-term prospects of the underlying investments and the ability of investors to meet their goals. I think the professionals certainly do have some advantages over individual investors. They get paid to do a job and charging other people for that comes with standards around education and experience, which we've mentioned before. They also get support from other professionals that we see that they do have analysts that work for them and there's time to dedicate to the pursuit of investing and the access to tools and data.

When you've decided whether you have the propensity to invest in direct equities, based on whether you have one of these edges, you're able to continue with the rest of the decision tree to select investments. So step one is deciding between direct equities versus collective investment vehicles. When we speak about individual securities, they are equities and stocks. These are ownership stakes in a company listed on a stock exchange. When we're speaking about collective investment vehicles, these are professionally managed investments and they can be listed on an exchange. So these are exchange traded funds or ETFs and LICs or they can be unlisted, so managed funds.

Step two is deciding between active or passive if you're going for a collective investment vehicle. When we're talking about active strategies, that involves picking assets that the manager think will help them reach the goals of the fund. For example, it could be CPI plus 2% or to beat a benchmark that they might be market weighted to an index. Passive strategies track a market weighted index or portfolio. An example is the ASX 200, so the top 200 companies of the ASX. However, it's worth noting that you don't need to exclusively use one or the other. You can be a proponent of both active and employee passive when you're constructing your portfolio.

So to understand where each strategy might fit in your portfolio, consider the following questions. The first is how efficient is the underlying market? So what this means is we're looking at the degree of efficiency and that refers to how much the prices in the 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? And this is normally a lot harder in markets where there's intense competition and there's widespread investor interest.

So if we look at an example, a good one would be large cap stocks. If you're investing in active funds that are looking mostly at large cap stocks like the ASX 200, you're going to find it quite difficult to achieve a return that outperforms the benchmark. These companies that are in the ASX 200 are heavily researched by institutions, they're researched by fund managers, brokers, so they're really well understood. Lower down in the market where there aren't eyes on companies and traditional brokers don't have coverage, there are opportunities for these companies to be misunderstood. And that's where managers and individuals find attractive buys. Generally, what we see is less efficient markets are the markets that investors are less interested in and there are structural issues preventing investors from actually getting access to these markets.

So for example, international markets. This is supported by a report that we do which is called our Active Passive Barometer Report. So we publish this report half yearly and it puts into context how active managers are performing against their benchmarks. And it is a U.S. study and it is U.S. focused, but the results reveal that in general, actively managed funds have failed to beat their benchmarks, especially over a long time horizon. Only 24% of all active funds topped the average of their passive rivals over the 10-year period ending June 2020. When we're looking at the success and where it lies, it was higher among international funds, real estate funds and bond funds. So these are all these funds that aren't as well researched, they are in asset classes that aren't as well researched. The lowest success rate was that large cap U.S. funds, which are extremely well researched and watched.

The second question is 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 the returns. If we see that 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're paying to access these markets and whether efficient markets are worth consigning to active managers. It's not uncommon for active managers in Australia to charge between 0.8% to 1.5% as a management fee, with many of these active managers still failing to beat their designated benchmarks.

So the active passive barometer report also reveals that price doesn't always mean value. So what we saw is that the cheapest active funds succeeded about twice as often as the priciest ones. So this not only reflects cost advantages and how it translates to performance, but also differences in survival. So 65% of the cheapest funds survived, where 49% of the most expensive did so. And although fees shouldn't be the deciding factor of what you invest in, it's very difficult for active managers to find opportunities in markets that are diligently watched. So if you're looking to allocate your portfolio to large cap stocks in developed markets like Australia, the U.S. and the U.K., historically what we've seen is that passive funds have been the better bet.

The next question is how liquid are the underlying assets? Index investing works best when underlying holdings are regularly traded at a high volume. So index managers are looking at low tracking error in less liquid markets, and this is harder to do as buy-sell spreads are wider and the price of assets may move from the manager before they can actually build a position. So if you're 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.

So the last branch of the decision tree is with collective investment vehicles, whether you go for a listed investment or an unlisted investment. An exchange traded product is a product that is traded on the stock exchange. So these include equities, they include exchange traded funds, so ETFs and LICs, which are listed investment companies. And non-exchange traded product is a product that's not listed, so this is like a managed fund.

Transaction costs are also a consideration, so if they're not managed, it can eat into your investment returns. When we look at listed vehicles, so equities, ETFs and LICs, they incur brokerage every time you buy or sell, so it has to be a consideration for investors if you're either investing frequently or if you're drawing down on your investment. So this might be if you're an investor in retirement and you're making withdrawals. If you're investing infrequently or in lump sums, it broadens your options to investments that do incur brokerage. Then we move on to management fees. Management fees make a large difference to your overall outcome. Generally what we see is managed funds have higher fees because they have higher administration costs and they can be hosted on platform products which do incur additional costs.

The graph that we're showing now shows the detrimental impact of management fees. The impact of a 0.5% difference in fees on $100,000 investment and we're making $1,000 additional investments every month over 20 years with 6% per annum return, it's over $47,000. However, this isn't 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, especially for individual investors, whether that's due to large minimum trades or the ability to transact in the market or there's regulatory reasons why you're not able to access it.

Some examples of this include credit, microcap and types of infrastructure. Another reason why you might choose to pay higher fees is if you don't have enough capital to build a diversified portfolio without prohibitive transaction costs, so these were the brokerage costs that we were talking about before. Studies show 12 to 18 shares are required to diversify away 90% of the non-systemic risk or individual company risk in a portfolio. This is a situation where collective investment vehicles might be right for you, so this might be a managed fund, an ETF or a LIC. Ultimately, you have to decide whether the management fee is earned or if you're better off investing choosing individual investments.

Do you believe that you have a competitive advantage that will help you reach your goals? 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're able to invest with an amount where brokerage makes sense and the investment makes sense, ETFs might be the right option for you. If you're after specific active management strategies, LICs or managed funds may be right for you as they have more options.

Then we move on to trading flexibility. Trading flexibility is important for some investors who'd like the option of buying or selling assets whenever they need to access their cash. Managed funds, on the other hand, they're unlisted, so what happens is a unit price is struck each day. What this means is that you're not able to trade intraday 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 in our opinion. Having flexibility to trade intraday is not a priority over a long-time horizon.

Then we have minimum investments. For listed vehicles, they are effectively non-existent. You are able to purchase one unit of a stock, of an ETF or a LIC and that will be the minimum to invest. However, this doesn't always make sense for individual investors. 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 doesn't mean you should purchase one unit for $3 and then pay $10 in brokerage. Therefore, what we think should happen is that investors should apply logical minimums and they should impose them to ensure the amount of units you are purchasing makes sense. For unlisted assets, managed funds, minimum investments are decided by the manager.

When we look at minimum investments, they do differ greatly between providers. There are some managed funds that can start at $500 and then we have other managed funds with $100,000 initial minimum investments. For lower minimum investments, you can access funds through platforms in Australia.

And the last consideration is behavioral risks. And behavioral risks reflect our tendency as humans to act emotionally during volatility. We're driven by fear and greed, which is a 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's still a high probability that an investor will panic when the market is going down and the fear of missing out on profits when it keeps climbing.

So these actions have been shown to be to the detriment of the returns an investor achieves. And we call this the behavior gap. And the behavior gap is the gap between an investment return and the return that 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.

The Morningstar Fair Value Estimate is designed to prevent these types of behavioral mistakes that we make. Changes in security prices don't impact the fair value estimate, but they do change the Morningstar Analyst rating as we've spoken about before.

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, they do promote this while others encourage over trading. So what we see with managed funds is that they have a higher barrier to trade. And this is called a speed bump. And this can encourage you to think twice before making an irrational decision or a transaction. They price one today and that means that you don't see intraday volatility like you do with listed assets. So most managed funds, they also require paperwork to redeem assets, which also acts as a physical speed bump where investors might think twice about making a transaction because of the time and effort it takes to actually make that withdrawal. Listed assets are a little bit different. These barriers are not as high and you're able to freely trade between market open and close.

So the best thing that investors can do is start with an investment policy statement an IPS, which is a tool used by professional investment managers and investment professionals. 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 it ensures you're being thoughtful about the decisions that you're making. And deliberate about the decisions that you're making. An investment policy statement 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 and that enables you to stay focused on the long-term objectives of your portfolio. This way you can ignore all the short-term noise in the market and you can avoid irrational decisions.

So we've created an investment policy statement template that you can use to document your strategy. What you can do with this is you can tailor it to your circumstances and to your preferences. So if you're investing for multiple goals, so your retirement as well as a home purchase, for example, it will probably make sense to create a separate one for each goal. So the following steps are required for your investment policy statement. Step one is documenting your goals. Documenting your goals might seem quite straightforward, but there's more to this than meets the eye. Quantifying and prioritizing your goals is paramount. If you don't quantify, you can't measure your success. And if you don't prioritize, you risk lack of focus hindering from achieving your goals.

Quantifying how much you'll need for retirement is particularly complex. What it requires you to do is forecasting not just unknowable, such as your life expectancy and rate of return, but also factor in your own variables. So this includes how much will your spending change in your retirement? Do you have non-portfolio sources of income such as a government pension? There are a lot of resources online to lean on and these include 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 we did speak about, and this can be part of the process of documenting your goals. Step two is outlining your investment strategy. The most successful investment strategies are straightforward and succinct. For instance, if you look at a strategy for those embarking on their investment journey, it might 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 a retiree 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 three, 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 Investors Portfolio Manager, which allows you to input these electronically and print out an appendix of all of your investments. When we come to step four, it's document target asset allocation. If you've not constructed your target asset allocation for your portfolio, you can use Morningstar's Guide to Portfolio Construction to understand how target allocations work and what suits your circumstances. 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% to 85%. For major asset classes, stick to a range between 5% to 10%.

Step five is outline investment selection criteria. In your investment policy statement, you must outline investment selection criteria that will provide guidelines for the type of investments that you want to hold in your portfolio. So for example, if you use Morningstar's research in your investment decision-making process, what you could do is you could specify that your equity holdings must have at least three stars or your managed funds must all be rated bronze or better. Step six is specifying monitoring parameters. Implicit in outlining all of the above policies, so from asset allocation to investment holding specifics, is that you're going to periodically check in on your portfolio to ensure it's still on track to reach your goals. We'll discuss more in the next section of this course.