Preparing for retirement with patient value

"Before then I had a ragbag collection of punts on individual shares, directly held investment trusts and different pension pots," he says. "I got fed up with high charges and mediocre performance so decided to manage my own money. I started reading Investors Chronicle carefully and have been gradually moving everything into individual savings accounts (Isas) and self-invested personal pensions (Sipps), which has involved some sale and repurchase charges but will save me costs in the long run. I have a six-figure portfolio of value stocks which I hope will enable me to retire early at 60 with a £20,000 income.

My investment objectives are also to have a substantial savings buffer in case of need such as redundancy, sickness in old age or children asking for help onto the property ladder.

My risk appetite is high as I am lucky enough to have a defined benefit pension from previous employment which will give me £20,000 a year linked to retail price index (RPI) inflation from age 60. If I stay in my current job I can also expect £10,000 a year from a defined benefit pension from age 65. I can therefore take greater risks with my investments and hold equities for the long term. If I lose the lot I will still have a home and a pension. I will just have to work a bit longer.

At retirement I intend to keep the Isas fully invested and use dividends for income. I aim to take advantage of new Sipp rules to channel money out of them and into Isas, using drawdown and tax-free lump sums.

I am a patient value investor and content to wait for dividends to compound. I like defensive shares that pay consistent and rising dividends, and prefer cash-rich companies well-placed in their markets with international exposure.

I am wary of growth shares and I only trade a few times a year. When I rebalance or take advantage of temporary price anomalies I top up core holdings. If a share's price gets too high I sell it.

All my holdings are in an Isa and Sipp with Alliance Trust Savings as it has fixed low charges. I am building up passive exchange traded funds (ETFs) and trackers on a monthly basis using pound cost averaging.

My portfolio has made substantial gains in recent years. I realise this is because of a favourable market rather than my stock-picking ability and don't expect these favourable conditions to continue, so I want to rotate a significant portion of my portfolio into passive funds over coming months. I am content with 5 per cent growth a year.

I have learned from painful experience to admit when I am wrong and take a small loss now rather than risk a bigger loss later. The portfolio also generates useful income, all of which I reinvest.

I sometimes invest heavily when I see a good company such as BAE (BA.) or GlaxoSmithKline (GSK) temporarily out of favour. For example, a few months ago I added substantially to SSE (SSE) and I'm sitting on a profit of £4,000 plus a 6.4 per cent annual dividend.

I recently sold half my holdings in RPC (RPC) at a handsome profit and sold out of Carillion (CLLN) before its profit warning.

I don't mind volatility and during the financial crisis in 2008 and 2009 I set up automatic monthly purchase orders on value stocks and kept buying without worrying about fluctuating prices, which generated gains.

My last three purchases were:

Vanguard FTSE Developed World ex UK Equity Index Fund Acc (GB00B59G4Q73)

Vanguard FTSE Developed Europe ex UK Equity Index Fund Acc (GB00B5B71H80)

Vanguard FTSE Emerging Markets UCITS ETF (VFEM)

I have started using tracker funds as a low-cost way to achieve overseas diversification for the portfolio and spread risk. I want to build up ETFs and trackers to 40 per cent of the portfolio. My target asset allocation is:

*45 per cent individual UK stocks;

*30 per cent low-cost US, global and Europe equity ETF tracker funds;

*10 per cent low-cost emerging markets ETF tracker funds;

*10 per cent bonds; and

*5 per cent cash to invest during dips.

I do not think government bonds are safe or attractive at present, although corporate bond funds or individual corporate bonds might be of interest. I would welcome suggestions on this and my target asset allocation.

On my watch list I have db X-trackers MSCI AC Asia ex Japan High Dividend Yield Index UCITS ETF (XAHG), and I am considering selling Balfour Beatty (BBY), Tesco (TSCO), Smiths Group (SMIN), BG (BG.) and Rio Tinto (RIO).

Chris Dillow, Investors Chronicle's economist, says:

There's a lot I like about this.

Most importantly, your objectives are realistic. Assuming an annual real return of 4 per cent per year over the next 11 years, this portfolio should grow to around £520,000 in today's money by the time you're 60. That should easily give you an income of £20,000.

I also like your preference for defensive, cash-rich growing companies and aversion to growth stocks. This feeds into two well-established ways of beating the market - to hold both lower-risk stocks and quality ones, where quality is based on measurable factors such as profits and pay outs. In this context, I'd quibble with your claim that your good returns are due to favourable market conditions rather than your stock-picking ability. It's not sufficiently realised that these two are not the only sources of good returns. What also matters - and this is partly the secret of Warren Buffett's success - is the ability to spot which investment styles will outperform on average and over the long run. And you've done this.

I also like your recognition that you might be able to work longer as a risk-management strategy: your human capital can protect you from fluctuations in equities. I like too your attraction to low-cost tracker funds, and your willingness to use regular investments as a way to enforce the discipline of buying on dips.

As for your target asset allocation, I have five observations.

First, while I agree with you that government bonds are unattractive in a central scenario, as does the market because an upward sloping yield curve means prices are expected to fall, they might still have a role as protection against low probability high-cost risks. In a serious bear market, even the best quality stocks will fall. Granted, using automatic monthly buying helps you profit from this in the sense that good future returns hedge you against bad current ones. But this protection might not be sufficient. If we fall into secular stagnation we might not get a big post-dip recovery in prices. And if the bear market comes when you are close to retirement, you might not have enough investing time to take advantage of the lower prices. Government bonds help protect you from this.

Second, be aware that corporate bonds carry cyclical risk, in the sense that they would fall in price insofar as a recession increases credit risk. The lower the quality of the bond, the greater this risk is. This matters, because your stock holdings would probably also fall in recessions. In this sense, corporate bonds don't diversify risk well.

Third, there is a massive distinction between bonds and bond funds - so much so that you should think of them as different assets entirely. If you hold a bond to maturity, you are taking on only credit risk and the risk of unexpected inflation - the risk of not being paid back or being paid in devalued money. If you hold a bond fund, you are also taking on price risk - the danger that a swing in investor sentiment will move prices. If you want to lock in wealth at a future date you need specific bonds maturing on that date, not funds.

Fourth, be aware that most of the time international diversification doesn't spread volatility risk because overseas shares fall as UK ones do. This doesn't mean you shouldn't diversify internationally. It's just that doing so protects you from other dangers such as the risk of sterling falling a lot or the UK suffering prolonged weak growth.

Finally, there is a risk involved in confining your UK equities to specific stocks and not holding a UK tracker fund - style risk. While it is the case that quality defensives should outperform on average, it's very likely at some poinr in the next 11 years that growth stocks will enjoy a period of great returns, in which case your UK stocks could do badly. Think of what happened during the tech boom of the late 1990s. Granted, your overseas tracker funds might protect you from this. But be aware that there is this risk. Even the best portfolios take on risk because it is unavoidable and comes in many different guises.

Helal Miah, investment research analyst at The Share Centre, says

Given that you have two pension funds that should provide a decent level of income in your retirement, you can afford to take a bit more risk with this portfolio. However, it's nice to see that you have taken a conservative approach with realistic targets.

In recent years your portfolio has performed very well. However, I would give you more credit than you give yourself. The fact that you are a patient value investor who reinvests all the income is also a significant factor as to why your portfolio has done so well. Buying big blue-chip dividend-paying defensive stocks that have experienced dips while others were panic selling has benefited your portfolio. You went against the grain, stuck to your convictions, and have been resilient enough over a good numbers of years to give the strategy time to work.

At 49 years old I think it's perfectly reasonable to continue with the same strategy as you have time on your side, and reinvesting the dividend income will produce surprisingly positive results over a longer time horizon. However, it is worth locking in some of your gains every now and then, like you have done with RPC. Among your existing holdings the obvious one is BAE Systems. The company has been performing fairly solidly and paying a good level of income with a large order backlog. However, because budgets cuts in the UK and US will continue to hamper defence spending, it will become ever more reliant on winning contracts from Middle Eastern and other countries. It also represents your largest holding when you take both your and your wife's portfolio together.

You are considering switching some of your investments to increase your exposure to index-tracking ETFs. While this a is a low-cost way of diversifying your exposure, I would bear in mind that your strategy so far has been fairly selective in the type of companies you buy into: defensive, cash generating and value biased. This strategy is far harder to implement if your portfolio becomes more index tracker focused. When investing in trackers you end up with a higher portion in stocks that have done well in recent times and vice versa. You may also end up with significant exposure to sectors you don't want. For example, with a FTSE 100 tracker your portfolio will be mining, oil and gas, and financials heavy instead of your current industrial, engineering and infrastructure focus.

While I am not suggesting you avoid tracker funds altogether, I think they should rather complement your individual shareholdings. It is certainly worthwhile using trackers or funds to gain exposure to international markets.

On the whole, your proposed asset allocation is reasonable, although some might argue that a slightly larger exposure to the US, or small exposure to small caps, is warranted at the expense of UK large and mid caps. An increased exposure to small caps could be through funds if you are uncomfortable with direct holdings. While your target of 5 per cent return a year is conservative, an increased small-cap exposure could help achieve returns in excess of this and make the portfolio more exciting.

The rhetoric that we have been hearing from corporate bond fund managers suggest good-quality bonds are hard to come across, with covenants tending to favour the borrower over the lender. This suggests valuations are looking stretched and liquidity is tight in the market. In terms of government bonds, I agree the yields are too low to look attractive. The time to begin increasing your exposure as part of your life-styling asset allocation transition will be if and when the economic recovery goes to plan, and the Bank of England goes through with interest rate increases up to the new 'normal' levels.

David and Katherine Hunt portfolio

Source: Morningstar & Investors Chronicle, as at 6 August 2014