Morningstar’s best research on the foundations of investing
The quality of your portfolio is determined long before you choose your first investment.
Investors love to talk about what’s happening in the market, the best ETF to buy or which star fund manager is going to shoot the lights out. Morningstar’s research suggests they’re starting in the wrong place by focusing on investments instead of objectives.
Across Morningstar’s research on behavioural finance, portfolio construction and diversification, a common theme emerges - successful investing isn’t about finding the perfect investment. It’s about building a portfolio that gives you the highest probability of achieving the life you want.
Here are some of the most valuable lessons from Morningstar’s research.
Your first investment decision isn’t choosing an ETF, it’s defining your goals properly
Morningstar’s portfolio construction framework starts with a step many investors rush through or ignore all together: defining goals. This is the step you should take before calculating required returns, deciding on asset allocation or selecting investments. Without knowing what success looks like, it’s impossible to know whether a portfolio is appropriate.
Morningstar has conducted research to understand the best way to uncover financial goals. Understanding your financial goals is paramount to being able to properly plan and invest for them.
Due to cognitive biases, people can be strangers to themselves and what you think may be a financial goal might not actually reflect your true motivation.
When investors that took part in the study were asked outright to name their financial goals they tended to list common financial goals. For example, retirement or buying a house.
These are called ‘surface goals’. When investors were put through a framework to dig deeper for their goals – they ended up changing. The changes reflected their values like donating to causes that they believe in and maintaining relationships with family and friends. These are called ‘deeper goals’.
For example, a person’s original surface foal could be to buy a vacation home in Watsons Bay. Upon further review, this person’s deeper goal may be to spend dedicated quality time with their family, which they hope to achieve via the Watsons Bay vacation home. However, this same Deeper Goal can also be achieved by buying a much more ‘affordable’ house in Avoca.
How to dig deeper for goals
Step 1: List your top three financial goals.
We suggest doing this privately, so you don’t feel anchored to what first comes to mind or embarrassed if you decide to change your mind later.
- Most important goal:
- Second most important goal:
- Third most important goal:
Step 2: Take a look at the master list of common financial goals.
Are any of the goals on the list important to you? Write down the ones that are.
- To be better off than my peers
- To pay for personal self-improvement (e.g., go back to school, learn a skill)
- To experience the excitement of investing
- To start a new business
- To buy a house
- To help pay for my kids’ college education
- To stop working and do something I love
- To go on a dream vacation
- To relocate in retirement
- To care for my aging parents
- To give to charity or other causes I care about
- To feel secure about my finances in retirement
- To feel secure about my finances now
- To leave an inheritance to my loved ones
- To retire early
- To pay for future medical expenses
- To not be a financial burden to my family as I grow older
- To manage my debt
Step 3: Look at your initial list and master list. Consider the goals you wrote down and the goals you checked. Of these goals, what are the top three? Write them down in order of importance.
- Most important goal:
- Second most important goal:
- Third most important goal:
Step 4 (optional): Revisit the master list of common financial goals and cross out the goals that are least important to you. Sometimes identifying what you don’t care for can help clarify what really drives you.
The results
In the study, 75% of people change at least one of their top three financial goals after going through this process. The findings of the study suggest that investors benefit from a structured process when they’re defining their goals.
As an investor, truly understanding your goals increases the likelihood that you will stick to your plan. It can also help with achieving what you want sooner , or with less risk in your portfolio – like in the example of the vacation home.
Before investing, build your financial resilience
One of Morningstar’s behavioural studies reaches a conclusion that surprises many investors. The biggest improvement many people can make isn’t finding a better investment. It’s building a larger emergency fund.
Financial wellbeing is split into two categories that need to be achieved to fully attain it. The first is objective, and the most obvious. It is the ability to meet current and future financial needs.
The second is a little more nuanced. It is the subjective feelings of being financially secure and being able to enjoy your life. This feeling will vary from person to person and will require different levels of the ‘objective’ goal to be achieved.
For example, one person may feel financially secure holding six months of emergency savings. Another person might still think this is not enough and want at least two years of emergency savings in the bank to have peace of mind.
Financial stress impacts many of us and relieving that stress is a key determinant of our emotional wellbeing. According to the Australian Psychological Society, the number one source of stress for Australians is money. One of the leading causes of divorce is disagreements about money. It permeates into every part of your life and impacts your overall happiness.
Emergency savings are often viewed as a drag on returns because cash typically earns less than growth assets. Morningstar argues a focus on the low returns for cash is a misunderstanding of their purpose. Cash isn’t there to maximise returns, it’s an enabler of your overall investment strategy.
When unexpected expenses arise, an emergency fund prevents investors from selling long-term investments at the wrong time, taking on expensive debt or abandoning carefully constructed financial plans. In other words, your emergency fund isn’t separate from your portfolio.
Despite this, the study finds that many people struggle to build up an emergency fund.
In the study, only 41% had a fully funded emergency fund. Adding to this, those who did not have an emergency fund struggled to make progress on building this key enabler of financial success. Most had not reached half their target, and 25% had no emergency savings at all.
The likelihood of having a fully funded emergency fund was linked to both objective and subjective financial wellness - those who felt dissatisfied with their finances were less likely to have good emergency-savings behaviour, and this effect was larger when a person had lower amounts of investable assets.
However, subjective financial wellness was not always achieved, even by those with the highest investable asset base (more than $349,000 USD). They reported feeling financially dissatisfied. 30% of them failed to reach emergency-savings adequacy.
Emergency savings are critical for financial wellness – both objective and subjective. It is easy for individuals to ignore, but it is so critical that it impacts overall wellbeing. Achieving adequate emergency savings can also create a ripple effect with the feedback loop that our researchers mentioned, allowing you to achieve the dopamine hit that reinforces good behaviour.
Financial wellness and financial behaviours are bidirectional
The Consumer Financial Protection Bureau (CFPB) in the US has a framework for financial wellness that believes behaviour is a precursor to financial wellbeing. For example, paying off a credit card debt is the behaviour, and financial wellness is a result.
Our researchers believe that this relationship is bidirectional. For example, you fully pay off your credit card debt and this makes you feel better about your overall financial situation. This positive feeling prompts people by further compelling them to enact other good financial behaviours as they continue to chase that positive feeling.
Unlike every other person in financial services, I don’t run. But - I hear this is similar to a runner’s high. The great feeling that runners experience after a jaunt makes them continue to chase that feeling and continue their hobby of running. Good for them.
This is useful information to know. If financial wellbeing can be a catalyst for more good behaviours that strengthen that wellbeing, investors can focus on more than just undertaking good behaviours. Instead, you can take a step back from your financial situation and understand that you may be in an objectively better position than you think you are.
Final thoughts
Morningstar’s research on the foundations of investing consistently reaches the same conclusion.
Successful portfolios aren’t built by chasing returns or copying someone else’s investments. It is a more deliberate process of building a framework for success.
Start by understanding what you truly want from your money. Dig beneath the obvious answers until you identify the outcomes that really matter. Build financial resilience so temporary setbacks don’t derail your long-term plan. With this foundation in place, you can start to understand the investments that are going to get you to your financial goals.
