Bond holdings stand in the way of high returns

Chris Dillow, Investors Chronicle's economist, says:

My biggest gripe with this portfolio is that, in holding 53 assets (30 funds, 1 bond and 22 companies), it is over-diversified.

Think of it this way. In what sort of world would your European, Japanese, emerging markets, resource funds and UK equity portfolio do well? It's one in which global equities generally rise. But in this case, why not hold a global tracker fund, accompanied by some big positions in a handful of preferred funds or equities?

I ask because one problem with actively managed funds is their charges. You say you've left your independent financial adviser (IFA) because you wanted to reduce costs. Good. One of the first rules of investing is to minimise taxes and fees. But instead of handing money over to an IFA, you're handing it over to fund managers, many of whom charge a management fee of 1.5 per cent - a percentage point higher than many trackers. This is tolerable if they are doing something a tracker fund cannot, such as offering above-index performance. But the chances of a portfolio of funds doing this diminishes, the more of them you hold. You can end up with tracker fund-type performance without the benefit of tracker funds' lower charges.

My second gripe is that you are over-optimistic in expecting growth of over 10 per cent a year. Of course, equity volatility is such that there's a fair chance of getting such a return in one or two years. But it would be unreasonable to expect such returns on average over the long run; 10-year government bonds yield less than 2 per cent. To expect 10 per cent annual returns over the next 10 years thus requires you to believe that the expected equity premium is over eight percentage points a year. This is more than twice its long-term average: economists at Credit Suisse estimate that, since 1900, global equities have outperformed bonds by 3.5 percentage points a year.

I would assume - as a rough rule of thumb - that the long-term returns on global shares will average no more than 5 per cent a year in real terms, and quite possibly less.

To get 10 per cent a year requires you to hold a much more concentrated portfolio than you currently have, and to get lucky with those holdings. You need huge equity positions - so those bond funds would need to go - probably in high-beta emerging markets and in a handful of speculative stocks.

This raises the question which is ultimately a personal one: do you really need 10 per cent annual returns to fund your lifestyle? Or shouldn't you reduce your expectations and, if necessary, your outgoings?

Turning to your direct equity portfolio, this has a heavy weighting in small speculative stocks. Ordinarily, I'd recommend against this. History shows that, very often, investors have overpaid for glamorous growth opportunities. However, one thing urges me to give you the benefit of the doubt. It's that investors' sentiment - measured by the low level of the Aim index relative to the All-Share - seems unusually depressed now. This might mean that speculative stocks are unusually cheap.

But are you holding too many of them? In one sense, no. These stocks have unusually large volatility. This means you need to hold a lot in order to reduce the volatility of your portfolio.

On the other hand, though, the fact that they are so speculative means that correlations between them are lower than for most mainline stocks. Which means you can diversify with fewer of them.

But diversification has a price. It reduces upside as well as downside risk. Even if there's a 70 per cent chance of each individual stock beating the market - which would mean you're a great stock-picker, there's a stronger than 50:50 chance that six or more stocks will underperform, which would drag down your performance. If you really want to beat the market and back your stock-picking skill, you should own fewer stocks.

Ben Yearsley, head of investment research for Charles Stanley Direct, says:

In one sense Mr Oliver's situation is similar to many others in that he has a decent collection of funds and shares in his portfolio that have been built up over time, but is there a proper strategy?

Mr Oliver makes an interesting comment about being disappointed with his direct share portfolio - this is a common occurrence. Buying direct shares, and not getting caught out when a company goes wrong, is actually quite difficult, especially with smaller more volatile businesses. If you pick a 10-bagger you are laughing, however you can just as easily have the reverse and your holding goes bust and you lose the lot. This clearly means just for risk mitigation, you need a large number of shares in your portfolio simply to avoid the 'eggs in one basket' syndrome.

The other issue with mixing a direct share and a fund portfolio is doubling up. Mr Oliver has mining and petroleum stocks in his portfolio and also has natural resource funds. Whether or not the fund holds these stocks, there is the potential there and Mr Oliver won't know what the fund is doing day to day.

I will repeat myself here, if you want a direct share portfolio, you need a large-ish portfolio with a minimum ability to hold 25 stocks. You also need time to keep a close watch on your portfolio, especially if you hold small cap or Aim stocks. It does seem a slightly strange portfolio - a few large cap and the rest mid and small.

Turning to the fund portfolio, there are some quality funds in there. Notable highlights include Aberdeen Emerging Markets, Invesco Perpetual Income, Fidelity South East Asia and Jupiter European. In fact there are very few duds in the portfolio. I always wonder about property in a fund structure. If you want direct property you have the danger of being locked in if there is a run on the fund, if you hold property shares you just get equity risk. I'm not a huge fan of property funds currently, therefore I question the usefulness of these in a portfolio.

In terms of number of funds - the number is slightly high, but not too bad, at about 30 - Mr Oliver could do with chopping this down slightly, but only by about five funds. For example, why hold the M&G Strategic Bond fund and the M&G Corporate Bond fund - both are managed by Richard Woolnough and both have 80 per cent in investment grade bonds? Also why have both the income and accumulation units of the M&G Global Basics fund.

Mr Oliver should analyse the funds and see where his holdings actually are - he might be surprised! He then needs to decide whether those funds and the strategy fit with his aim of 10 per cent growth a year. Taking out the six bond funds, the portfolio does look reasonably high risk; however he has invested in core funds in the key areas: Invesco Perpetual Income, Aberdeen Emerging Markets, First State Asia Pacific Leaders, etc.

So, in summary - a good selection of investments, both in funds and shares, but you should look to ensure there's no doubling up and that you actually know why you own funds and that they fulfil your objective of achieving long-term growth.