Top marks for starter Isa portfolio

By Chris Dillow and Keith Bowman , 31 January 2012

23-year-old Alex Marshall has only been investing for two years, but is quite accepting and open to risk as he intends to keep investing for a number of decades. He aims for long-term growth while maintaining exposure in a variety of sectors. He says: "I have started investing at quite a young age, so I would like to have some advice about how to manage and build a growth portfolio. My portfolio is held within an individual savings account (Isa). I contribute £50 a month to each of the funds."

ALEX MARSHALL'S ISA PORTFOLIO

Source: Investors Chronicle. Price and value as at 31 January 2012

Chris Dillow, Investors Chronicle's economist, says:

There are three big things you're getting right here.

First, you're using your full Isa allowance. This obeys one of the first rules of investing - to minimise taxes. You should also consider starting a pension, as this also offers tax breaks. (Read our article pensions vs Isas).

Secondly, you're saving regularly. This imposes discipline in two ways. It forces you to buy when prices are low and market sentiment is depressed and thus when you might not feel like buying, even though expected returns in such times are often good. And it makes it less likely that you'll not invest because you'd rather buy consumer goods, instead.

Thirdly, you've started young which means you can get rich slow; even if real returns average just 3 per cent a year, you'll double your money before you get to my age. This means that, unlike older investors, you don't need to chase risky high returns even though you can afford to do so.

My quibble is your portfolio is less well diversified than you might think. Commodity stocks and funds are highly correlated with emerging market shares, as both are plays upon the same things - though whether these things are growth prospects in developing economies or low interest rates in the US is another matter.

This brings me to a bigger problem. It is plain wrong to think that you should hold long-run growth stocks just because you are a long-term investor.

This is for the simple reason that long-term growth should be priced into shares today. Prices of emerging market stocks are high because investors anticipate good future growth. But such high prices mean future returns will not be high, unless growth exceeds expectations - which is, to say the least, questionable.

In fact, one of the cornerstones of financial economics says that your equity portfolio should not be affected by your age or risk-tolerance. The two fund separation theorem says that risk-tolerant investors should hold more equities and less cash than risk-averse investors, but the composition of their share portfolios should not differ.

This is because if shares are priced correctly, risky ones will offer high enough expected returns to tempt anyone to hold them, relative to other stocks, while safer shares will offer lower returns. All stocks will be equally attractive.

Of course, shares might not be priced correctly. But if a stock is underpriced, it is underpriced for everyone. In this case, equity portfolios will differ from person to person to the extent that people disagree about what is underpriced, or about what is risky. But they should not differ on the grounds of different tolerances of risk.

In this sense, there's only one reason for you to hold more "growth" stocks than other investors - because you believe, more than they, that they are underpriced. Your age and risk tolerance should be irrelevant.

But should you believe they are underpriced? There's a good reason for you not to. History shows that investors have often misperceived growth. A dozen years ago, growth stocks were tech firms, many of which subsequently disappeared, not "old economy" ones such as commodity producers. Two dozen years ago, they were pharmaceuticals and biotech stocks, which are long forgotten. What looks like growth is often just fashion.

Luckily, though, I suspect there's no urgent need for a radical overhaul. With the Federal Reserve likely to keep interest rates low for some time, commodity and emerging market stocks - two of the main beneficiaries of easy money - could remain in favour for at least a while.

It might, however, be worthwhile to gradually shift away from your bias towards long-term "growth". There's a lot to be said for having an All-Share tracker fund as at least part of your portfolio. (Read about tracker funds here.)

Keith Bowman, equity analyst at Hargreaves Lansdown Stockbrokers, says:

Congratulations on your decision to start saving and investing at an early age. You gain a number of benefits when investing at a young age - primarily geared to the time during which your investments are allowed to grow.

The first and most important benefit is exposure to the power of compounding income. Albert Einstein once described this as the "eighth wonder of the world".

The 2011 Barclays Capital Equity Gilt Study quoted the example of £100 invested into UK equities in 1899. Without reinvesting dividends, the £100 would have grown to (nominal) £12,665 today, or real (inflation built in) £180. By reinvesting the dividends, however, these figures would be a remarkable £1.7 million nominal or £24,133 real today. Given the historically low current interest rate environment, we favour UK equity income funds.

A second major benefit is the scope which a long time period allows you to consider higher-risk investments. If any monies are likely to be required short to medium term, lower-risk investments such as bonds or cash deposit accounts would be more appropriate. However, with time available, you can endure the volatility which higher-risk investments normally bring, with longer trends having historically worked to the advantage of investors. Your higher-risk investments, for example in emerging markets, can also potentially equate to high returns over time.

Your use of tax shelters such as Isas when investing for the longer term is to be advised. Such shelters remove an investor from the attention of the taxman, enabling benefits such as compounding income to build up without being taxed.

Savings made on a regular basis to stock market-related investments also bring the benefit of 'pound cost averaging'. Instead of investing on a lump sum basis, you build a holding, often in a managed fund, by slowly buying small amounts over a long period of time. The practice spreads the cost basis out over time, providing insulation against changes in market price and broader stock market volatility. In effect, the issue of timing an investment is reduced.

As for your current portfolio, we would highlight no major concerns. You have selected a number of funds suitable for higher-risk longer-term investors, especially a number of emerging market funds, including Latin America, Russia and the broader Aberdeen fund. You have exposure to fixed interest assets via the Old Mutual Global Strategic Bond fund, while you have also considered other more specialist areas such as agriculture and gold.

As already touched upon, you should not forget the power of compounding income. While you hold the Henderson Higher Income Retail Accumulation fund, we prefer other income-oriented funds such as the Invesco Perpetual High Income or Walker Crips Equity Income.

In all, having first established a rainy day or emergency cash fund, the earlier individuals begin the process of financial planning the better.

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