Age 61 and aiming for £170k income from shares

ANONYMOUS PORTFOLIO, AGE 61

Source: Investors Chronicle, as at 21 September 2015

THE BIG PICTURE

Chris Dillow, Investors Chronicle's economist, says:

You have here a very clear strategy - and, I think, a good one.

I wouldn't endorse the more paranoid forms of your distrust of the financial services sector: individual savings account (Isas) and pensions are good tax wrappers and there's much more honest incompetence than outright thievery in the industry. Even so, your scepticism has one big advantage: it has kept you out of high-fee actively managed funds many of which underperform their benchmarks.

Also, your holdings of high-yield stocks are essentially sound. You say that you believe you are rewarded for taking risk. In the case of high-yield stocks, this is correct over the longer run. There's evidence from around the world that value stocks outperform on average. For example, in the last 25 years the FTSE 350 high-yield index has outperformed its low-yield counterpart by 1.5 percentage points per year: 9.2 per cent against 7.7. 1.5 percentage points might not seem much, but it compounds wonderfully: this is the difference between £1,000 growing to over £9,000 compared with less than £6,500 in this time.

However, the key word here is 'risk'. It's likely that the outperformance of yield stocks is due not so much to investors irrationally underpricing them - although this is possible - but to them carrying extra risks.

Historically, one of these risks is cyclical risk: in the last recession, for example, high yielders such as mortgage lenders and housebuilders got walloped. You don't seem to be taking very much of this; you are out of housebuilders, for example. But this doesn't mean you would escape unscathed from an economic downturn. Recessions usually see shares generally fall - there's a strong correlation between the FTSE All-Share index and industrial production - and this portfolio, like any other basket of shares, is exposed to market risk. Worse still, your financial shares might well underperform in such an event.

If we do see a serious downturn - which I think is a possibility rather than central scenario - your objective of maintaining your capital value in real terms will be too optimistic. You don't have enough non-equity assets for this.

There is another risk with high-yield stocks - growth rate risk. Very often, shares have a high yield because the market believes they offer little dividend growth and so investors require high dividends now to compensate for the relative lack of them in future. Sometimes, though, investors underreact to bad news about future growth with the result that shares can be overpriced even if they are on above-average dividends. This means they will fall despite nice yields. This was the fate of food retailers two years ago and mining stocks a year ago.

To protect yourself from this danger, pay attention to momentum. If a stock is on a nice yield because it has fallen a lot in price recently, beware - because it could fall further.

There is, though, a new danger in higher-yield stocks: political risk. Labour's new leader Jeremy Corbyn wants to nationalise utilities, which might at best mean we see heightened volatility in hitherto 'defensive' stocks such as Centrica (CNA) and National Grid (NG.). Whether this risk is worth taking is one of those many matters in which opinion weighs heavier than evidence.

In stressing these risks, I don't mean to say this is a bad portfolio. Not at all; I stress that history tells us that many of these risks have on average paid off in the past. As long as you are aware of these risks, the portfolio is okay.

Louis Coke, investment manager at Charles Stanley, says:

Before looking too heavily into the individual stocks in any portfolio, it pays to take a step back and assess the overall mandate - ie, what you are trying to achieve, the size of assets available and risk level you are happy to take.

Achieving a positive 'real' rate of return is an excellent base case to start from, and averaging 5 per cent yield from your portfolio is tough, but achievable.

I would sound a note in respect of your future income requirements, though. Based on the value of your portfolio now and the additional cash likely to come through, you would need a yield of 7 per cent to meet your £170,000 income need.

You need to establish whether you are happy to gradually draw down capital in order to meet this cash flow requirement, should the portfolio not produce this rather high level of income.

Rosie Bullard, portfolio manager at James Hambro & Partners, says:

We agree with the equity bias in order to meet the requirement of maintaining the real capital value of the assets over time, but we also favour investing a proportion of portfolios into alternative assets to dampen volatility. We agree with the strategy to hold individual equities on a long-term basis but stress the importance of remaining flexible as there are points during a cycle when certain stocks and sectors will not perform as well as others.

The natural yield requirement is high at over 5 per cent, particularly when compared with the current yield on a 10-year gilt at less than 2 per cent, and the yield on the FTSE All-Share index, one of the higher-yielding markets globally, at 4 per cent, particularly as the latter has been boosted by the rise in the yields on oil & gas and mining stocks as share prices have fallen; high yields do not always equal high total returns.

It would be more realistic to expect a real return from income and capital of 5 per cent a year.

HOW TO IMPROVE THE PORTFOLIO

Company shares

Louis Coke says:

I agree that on many occasions you are rewarded for taking on risk. However, having the vast majority of the portfolio in the equity market leaves it rather exposed to any downturn in general.

Also, the portfolio is rather UK centric so some consideration to overseas territories and companies might be appropriate, both for growth and for diversification. You may want to take a look at some more FTSE 100 exposure in addition to overseas investments in order to obtain these international earnings, while broadening the reach of the portfolio across the market cap spectrum.

I would question your holdings in Centrica (CNA), J Sainsbury (SBRY) and Anglo Pacific (APF) because there might be better value to be had elsewhere for this scenario. I note your belief that it is hard to add value by stock picking, and indeed this is true - a lot of research is required to achieve this. With this in mind, an exchange-traded fund (ETF), or perhaps an 'active' ETF might be appropriate. ETFs offer exposure to a basket of stocks with a certain criteria, removing some of the stock-specific risk and for a low cost.

Rosie Bullard says:

The number of holdings appears appropriate without any positions being too large. We would, however, suggest you reduce the bias to financial stocks and instead add to areas such as the UK domestic economy. Companies such as Booker (BOK), Next (NXT) and Taylor Wimpey (TW.) all continue to produce strong results and are supported by attractive dividends.

We also urge caution on the so called 'bond proxy' stocks as the interest rate cycle starts to turn and would suggest reducing the utilities held.

Most importantly, though, the portfolio would benefit from international diversification. You might consider adding individual holdings in the US and Europe in sectors not covered by the UK stocks currently held. Examples to consider include American multinational technology company Google (US: GOOGL), international life sciences company Eurofins (Fr: ERF) and Swiss flavour and fragrance manufacturer Givaudan (Sw: GIVN).

Closed ended-funds

Stephen Peters, investment analyst at Charles Stanley, says:

The selection of listed funds is interesting and definitely meets your requirements for a high yield. Many are good funds, with HICL Infrastructure Company (HICL)* being one of the most successful alternative asset funds listed in the past decade or so. If you bought GLI Finance (GLIF) after it raised money, you would have enjoyed strong capital growth as well as a high income.

I'm not sure many of them would necessarily fulfil your preferences for cheaper assets, with many charging performance fees or high level of management fees.

Your objective to get a high and growing income and protect the value of your capital is only possible if you can invest for 10-year periods. This would allow the smoothing out of market volatility, and if it can be done is a highly admirable investment approach to take.

If that is the case, you should consider some of the most deeply out-of-favour asset classes now, such as emerging markets and commodities. Some investment trusts will pay income from those asset classes and may be of interest [Ed: See the IC Top 100 Funds for suggestions].

You should look at the valuation of some of the listed funds, particularly those investing in infrastructure and commercial property, and whether you would be willing to tolerate an evaporation of the premium at which those trusts trade.

Fund suggestions

Rosie Bullard says:

We would also add exposure to Japan, given the significant ongoing corporate and economic change, with the currency hedged back into sterling, via the JOHCM Japan Dividend Growth Fund (IE00BKS8NT50). We would sell the emerging markets exposure, given our concerns about the outlook. If income generation remained of interest, we would also add a fund such as Artemis Global Income Fund (GB00B5ZX1M70)*. While we have a preference for individual equities, funds can add value where they have exposure to a particular area or theme and where the manager consistently outperforms the index net of fees.

*IC Top 100 Fund. You can watch deputy personal finance editor Leonora Walters interview Jacob de Tusch-Lec, fund manager of Artemis Global Income here.

*None of the above should be regarded as advice. It is general information based on a snapshot of the reader's circumstances.