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Investing in growth to buy a home

Our reader hopes to save enough to buy a home within 10 years.
February 4, 2016, Jason Butler and Tim Stubbs

Chris is 24 and has been investing for eight years - since he was 16. He focuses on growth and reinvests all his dividends. Almost all his investments are held in individual savings accounts (Isas).

Reader Portfolio
Chris 24
Description

Stocks and shares Isa

Objectives

Buy a home

"My long-term investment goal is to be able to buy a house and remain mortgage free in the future," he says. "However, I've yet to decide whether liquidating my investments to decrease the need for a mortgage, or taking income payments from the pot to pay the mortgage would be the best way forward. Hopefully you can point me in the right direction.

"I've still got an investment window of another five to 10 years before I would consider a house purchase. But contributing to my Isa is harder now due to increased monthly outgoings.

"I'd say my attitude to risk is moderate. Most of my money is in large companies, however, I like to dabble with derivatives occasionally when I have what seems like an intelligent speculation and I can find a good entry point.

"My last three trades were closing a FTSE 100 short mini contract (6699.3 - 6158.5), selling Sky (Sky) and buying BT (BT.A). I have on my watchlist Rolls-Royce (RR.), AstraZeneca (AZN), Auto Trader (AUTO) and Blackrock World Mining Trust (BRWM). I will look to financials when interest rates start to rise.

In terms of funds I'd like to gain more exposure to Asia and India."

 

Chris's portfolio

HoldingValue (£)% of portfolio
Barrat Developments (BDEV)5,605.127.02
Taylor Wimpey (TW.)5,139.196.43
Blackrock World Mining Trust (BRWM)1,177.351.47
Royal Dutch Shell (RDSA)2,432.123.05
BP (BP.)1,125.251.41
Carillion (CLLN)3,617.604.53
EasyJet (EZJ)6,039.917.56
Unilever (ULVR)8,930.8211.18
Hikma Pharmaceuticals (HIK)5,788.647.25
GlaxoSmithKline (GSK)2,793.983.5
Old Mutual (OML)3,129.103.92
BT (BT.A)4,292.345.37
SAB Miller (SAB)3,881.824.86
Associated British Foods (ABF)3,627.544.54
Schroder European Alpha Income (GB00B9GTQ502)5,566.636.97
Fidelity Emerging Markets (GB00B9SMK778)2,139.272.68
M&G Global Floating Rate High Yield (GB00BMP3SC51)7,525.789.42
JPM US Smaller Companies IT (JUSC)4,876.556.11
Cash2,182.562.73
Total79871.57

 

THE BIG PICTURE

Chris Dillow, Investors Chronicle's economist, says:

You ask whether you should sell your shares to reduce the size of your mortgage. As you'll not buy a house for several years, it's difficult to answer this. But here's what I'd do now.

The argument for keeping equity holdings is that, with average luck, shares should offer higher returns than the mortgage rate. A typical mortgage rate now is around 5 per cent. But a basket of equities could easily return around 8 per cent: a 4 per cent yield plus 4 per cent nominal growth if prices rise in line with nominal gross domestic product (GDP). The equity premium - the gap between equity and gilt returns - could well be higher than the mark-up of mortgage rates over gilt yields.

You might think that the counter-argument to this is that mortgage rates will rise. I'm not sure this is a big problem. Unless the Bank of England makes a mistake, the circumstances in which mortgage rates would rise would be ones in which the world economy is doing well and share prices are rising - so your equity portfolio would also do well.

Instead, there are two other issues. One is that we can't be sure that long-run equity returns really will much exceed mortgage rates. The other is that if you have a big mortgage and a recession hits, you might lose your job and have to sell equities to pay the mortgage. This might entail having to sell when share prices are temporarily depressed. This breaks one of the first rules of investing - to never be a forced seller.

On balance, then, I reckon it's a tight call. But as it's one you don't have to make yet, don't worry about it. Comfort yourself with the fact that you've got quite a lot right.

 

Jason Butler, independent personal finance expert and author of The FT Guide to Wealth Management, says:

It's good that you've been saving regularly since 16. The power of compounding - returns on returns - has greatest impact over the long-term.

Your main objective is to buy a house in five to 10 years. Although mortgage funding is currently cheap it is unlikely to remain so when interest rates eventually rise, which is more likely than not in the next five to 10 years.

The holding period is a key factor in determining how to invest your capital and future savings. This is because short-term volatility in investment markets can cause permanent loss of capital if you need to sell to raise capital to fund the house purchase, when markets have suffered a fall. As a general rule, stock markets are falling one third of the time, recovering one third of the time and rising one third of the time.

I prefer to see people minimising debt rather than retaining investments. While stock markets have historically generated higher returns than the cost of long term mortgages of the majority of periods, there have been 15- to 20-year periods when this has not been the case. The monthly cost of servicing mortgage debt will also be a tangible strain on your monthly cashflow. The best mortgage deals are available to people with the highest deposits, typically 40 per cent plus.

 

Tim Stubbs, investment manager at Fiducia Wealth Management, says:

Have you considered boosting your exposure to the property sector? While you wait to climb onto the property ladder over the next five to 10 years, a risk you face while waiting is that land and property prices could continue rising significantly in that time.

Creating a larger property sector exposure - but perhaps with no more than a fifth or quarter of your monies given the usual need to spread risk and make use of multiple asset classes - would create an investment portfolio that could be far more aligned to your personal ambitions than, say, a purely equity-based portfolio.

The idea being that if property prices were to rise harming you as a future buyer, your portfolio could be designed to benefit, offsetting to some degree, in addition to providing reasonable exposure to an asset class that has historically generated strong returns.

 

HOW TO IMPROVE THE PORTFOLIO

Chris Dillow says:

Although it's small, this portfolio is nicely diversified. You've got a lot of defensives, such as Unilever (ULVR), GlaxoSmithKline (GSK) and Associated British Foods (ABF). This is good, because history tells us that such stocks tend to outperform on average over the long-run. But you've also got various types of cyclical exposure which include housebuilders, miners and emerging markets, and the last two are so highly correlated that they are virtually the same asset.

M&G Global Floating Rate High Yield Fund (GB00BMP3SC51) is also cyclical: in bad times credit risk rises which would hurt bonds on lower credit ratings.

Ordinarily I'd caution against such exposure, especially if your job is in a cyclical industry, as this poses the danger that you lose your job at the same time as your shareholdings do badly.

For you, however, there's an offsetting consideration. You want to buy a house. This means that house prices are, for you, a liability: you'll feel worse off if they rise. But cyclical stocks can be a sort of match for this liability. The circumstances in which house prices rise are likely to be ones in which UK house builders and the global economy do well. In this sense, your cyclical stocks would gain. Therefore what you lose from houses becoming more unaffordable you gain from the rising prices of your cyclical holdings.

Conversely, if the world and or UK economy falls on hard times and your cyclicals do badly, you can comfort yourself with the fact that housing is becoming more affordable, subject to the big proviso that you keep your job.

I'm not saying the hedge between house prices and cyclicals is perfect - it's not. Rather I am saying that cyclicals might make sense for someone in your position as a sort of hedge against rising house prices.

I'd caution you on your use of funds. The problem with actively managed funds is that their fees compound over time: over a 10-year period an extra percentage point of fees could mean that you lose £150 per £1,000 of original investment. Think carefully, therefore, before you buy more funds. In particular, ask yourself whether the fund you are thinking of investing in does anything that a cheap tracker fund or exchange traded fund (ETF) does not?

 

Jason Butler says:

Your existing portfolio is not well-diversified. There is no empirical evidence that holding individual companies and sectors is rewarded by higher returns than those from the stock market as a whole. There is also not a sufficient return premium for the significant risks involved in investing in high-yield bonds. The average ongoing expense of the four actively managed specialist funds you hold is about 1.25 per cent, which is quite high.

The words intelligent and speculation are a contradiction. With speculation, someone has to win and someone has to lose. With intelligent investing no one has to lose for you to win, because you capture the returns that markets deliver over time. A low cost fund of global index funds will give you investment exposure at very low cost and without you or investment managers trying to be clever.

So here's what I suggest you consider:

■ increase your cash reserve until it holds six to 12 months' core living expenditure;

■ ensure you have income protection insurance to pay you income in the event you are incapacitated for more than six months; and

■ replace your shares and expensive investment funds with something like Vanguard Life Strategy 80% Equity Fund (GB00B4PQW151) and direct future monthly saving into it.

 

Tim Stubbs says:

You could consider as part of a longer-term property buy and hold sub-strategy:

■ Maintaining your Barratt Developments (BDEV) and Taylor Wimpey (TW.) shareholdings or turning this into a basket of housebuilder stocks, say five to 10 holdings, with the intention of holding or trading between these stocks - as you prefer - for up to 10 years. If you believe we are not yet near the top of the property market cycle, you could argue that these shares may still offer significant upside, as well as attractive dividend yields today. But beware - these are high risk.

■ Bricks & mortar commercial property funds which provide direct exposure to assets such as UK offices and warehouses.

■ Adding real estate investment trusts (Reits) for further broad exposure.

I agree that emerging market stocks look interesting for long-term investors: sentiment is dismal and valuations are beaten down. We believe Asian stocks in particular look well positioned with regard to longer-term demographics, while the region is also a net beneficiary of lower energy prices. Adding Asian exposure would therefore present the advantage of complementing your existing UK equity and commodity-related exposures, which from a risk perspective is better than doubling up on commodity risk.

That said, we are a little cautious on Indian stock valuations. If you did wish to buy today, I would suggest being patient and gradually building up a position over time, just dipping a toe in the water for the moment.