Diversify to meet your income target and avoid nasty shocks

"I tend to be a buy-and-hold investor," says Tanya. "I would like to have a steady £10,000 income a year from my portfolio in five years' time. I aim to get a 5 per cent dividend a year, and also look for growth opportunities.

"I do not want to make losses though could lose a third of my portfolio without suffering hardship.

"I aim for blue-chip companies to account for 50 to 70 per cent of my portfolio. I look for a high dividend return, but have not succeeded particularly well in this due to my other criteria, which include looking for value increases and interesting opportunities.

"I have invested in Rolls-Royce (RR.), since it has good products and I believe it will recover from its current difficulties in a few years' time.

"I like Inmarsat (ISAT) due to its new technology - I am particularly interested in its non-terrestrial telephone systems.

"My largest investment is Lloyds Banking Group (LLOY). I have taken a long-term view on this over which time I think the share price will recover and it will make a good profit.

"I have a banking background, and I also invested in HSBC (HSBA) but am sitting on a big loss with that at the moment.

"My most recent trades were buying some more Diageo (DGE), and selling my holding in Elisa, (ELI1V:HEX) a Finnish telecom company, earlier this year when the price had reached €33 (£25.99). Its average yearly price is about €20."

She still holds Finnish shares and funds including electricity company Fortum (FUM1V:HEX), Nordea Bank (NDA1V:HEX), Nokia (NOKIAM0116:HEX), Kone (KNEBV:HEX) which manufactures lifts, Nokian Tyres (NRE1V:HEX), Neste Oil Corporation (NES1V:HEX), health technology company Revenio (REG1V:HEX), and Wärtslä (WRT1V:HEX), an engineering company.

She also holds funds managed by Nordea focused on areas including global equity income, India, and Nordic smaller companies.

"I have not sold anything during the past two years from my UK portfolio. I am considering buying AstraZeneca (AZN), although it looks too expensive just now. I would also be interested in putting money into ARM (ARM), the smartphone battery manufacturer, and topping up my holdings in Inmarsat and Lloyds.

"I am also wondering whether to add some index funds, so would be keen to get your views on this."

Tanya's portfolio

THE BIG PICTURE

Chris Dillow, Investors Chronicle's economist, says:

You say you aim for a dividend of 5 per cent a year. Assuming you can avoid tax on dividends through Isa holdings, this is mostly a good idea - with a big caveat.

I say this because higher-yielding stocks have beaten lower-paying ones on average over the longer run. In the past 20 years, the FTSE 350 High Yield Index has given a total return of 7.4 per cent compared with just 4.9 per cent on the FTSE 350 Lower Yield Index.

However, the phrase 'income stock' covers three different categories. You must distinguish sharply between these.

First, there are defensive stocks. These are often a genuine bargain because investors under-rate their ability to grow by exploiting their monopoly power.

Secondly, there are cyclical stocks, such as miners. These offer decent returns on average, but as a reward for taking an extra risk - the danger of doing really badly in a recession.

Thirdly, there are stocks which have fallen but not cut their dividend - yet. These are dangerous because they can be prone to adverse momentum effects: stocks that have fallen in the past 12 months tend, on average, to fall further.

Paul Derrien, investment director, Canaccord Genuity Wealth Management, says:

Your investment portfolio is split between equities, investment property and cash. This is not unreasonable and diversifies the risks you are taking in the direct equity approach that you have employed.

Your understanding of the amount of risk you are potentially taking is spot on - many investors do not appreciate this. Being willing to accept around a 30 per cent fall in the value of your equities in extremes is appropriate given the direct equity approach that you have, especially as you are likely to invest the cash reserve that you have into equities, and are willing to increase the portfolio with surplus income over the next few years.

There is also very sound logic in your forecasts for growing the portfolio to achieve the target level of income that you wish to generate over the next five years and you should be able to increase the current income yield towards your targeted £10,000 per year - ie a 5 per cent dividend return.

Your overall strategy looks sound and it is possible that you will meet your income target without too much intervention, but you need to diversify and rebalance your equities to avoid any nasty shocks. This will help to achieve that additional income stream you should have to enjoy retirement in a more secure manner.

Rachel Winter, private client broker at Killik, says:

Buying good quality companies and holding them over long time periods is a great investment strategy, and I think you're absolutely right not to trade heavily. That said, portfolios do tend to require minor adjustments every now and again, and you haven't sold any of your UK holdings for two years. Different sectors of the market grow at different rates, so it may be necessary to rebalance your portfolio periodically to ensure you have a suitable amount in each sector.

You say you could lose a third of the value of your portfolio without too much devastation, in which case you're right to be invested in equities. Although volatile, equities offer good long-term growth prospects. It's reassuring that you've got a cash buffer of £50,000, as well as an investment property, which I assume provides you with income.

In the current environment I would consider 5 per cent to be a high dividend yield, and I don't think it would be possible to achieve this across a whole portfolio without taking a certain degree of risk. A number of FTSE 100 companies have cut their dividends in the last couple of years, including Tesco (TSCO), Rolls-Royce, BHP Billiton (BLT), and Standard Chartered (STAN). I'd suggest looking at the dividend cover of the companies you invest in, which is a measure of how easily a company can afford to pay its dividend.

HOW TO IMPROVE THE PORTFOLIO

Chris Dillow says:

While your portfolio contains a nice weighting in defensives such as BT (BT.A), Unilever (ULVR), GlaxoSmithKline (GSK) and Diageo, it's also exposed to recent fallers such as Tesco, Rolls-Royce and Pearson (PSON). Maybe these are recovery plays. But - in contrast to cyclical and defensive high-yielders - history warns us that this is by no means assured: very many once-great companies are now defunct.

This brings me to your confession that you haven't succeeded in your pursuit of high dividends because you've strayed to other criteria. This highlights an underappreciated fact about investing: that you need the self-control to stick to what works: Warren Buffett has said that discipline and the "right temperament" are more important than IQ. Defensive investing tends to work. Straying into 'interesting' recovery plays might not.

One reason why so many investors do this is overconfidence. People overestimate their ability to predict corporate growth - which is in fact largely random - and so pay too much for 'growth' stocks and 'recovery' opportunities.

>Warren Buffett has said that discipline and the "right temperament" are more important than IQ. Defensive investing tends to work. Straying into 'interesting' recovery plays might not

I'm worried that this might explain your big holding in Finnish stocks. I'm not sure that this is motivated by a desire for diversification: your biggest Finnish holding, Fortum, is quite highly correlated with your biggest UK holding, Lloyds, simply because most stocks are correlated with each other by virtue of carrying market risk.

Instead, I suspect that it's because being Finnish you regard Finnish stocks as being relatively familiar. This is a very common habit: most investors have a home bias - a preference for local stocks. However, there's little evidence that this bias yields greater returns. Mere familiarity does not mean greater insight into the future.

That said, the home bias isn't the greatest investment sin; there's something to be said for holding stocks you feel comfortable with.

However, if you want genuine equity diversification, an easier and cheaper way to achieve it is simply by holding a global tracker fund or exchange traded fund (ETF). If you regard this - perhaps mixed in with some genuine defensives - as the core of your portfolio you might avoid the temptation to stray into more adventurous but less rewarding investments.

Paul Derrien says:

Where I feel that the portfolio could be improved is to address the issues of concentration risk. Your individual equity investments are not that well diversified and you have a significant Euro exposure risk. I am concerned about the potential effect of the currency movements on the portfolio value.

The UK investments are very unevenly spread. There are a number of good quality investments in your portfolio, so use any market opportunities to invest some of the cash in reserve to increase the diversification, and maybe sell some of the existing investments.

You said you were thinking of adding to Lloyds, and while there is nothing wrong with this as an individual investment, it already accounts for a substantial chunk of your equity investments so I would not increase this. If you wish to add index funds, consider iShares UK Dividend UCITS ETF (IUKD), which will give you access to the 50 highest income distributors in the FTSE 350 and yields over 5.5 per cent. There would be some overlap with your current investments, but it would be a more secure way of adding diversification, and help to achieve your income target.

The same diversification issues are prevalent in your overseas investments, and I am concerned that there is an emotional attachment to the Finnish market. You have very significant exposure to five Finnish companies in the energy, oil and telecoms sectors that have not performed well recently. This will have caused more volatility within the portfolio than I believe you should be experiencing, so I would try to use opportunities in the market to reduce the overall commitment to these companies and this country.

By all means use your knowledge of Finland to make investments, but be much stricter on the size of your allocations. If possible try to keep the individual investments to around 5 per cent of the equity allocation. Be more disciplined about this as it will decrease the risks of shocks to one area of the portfolio and will force you to be more diversified.

To help increase the diversification and income from your equities you could add in some global and small-cap exposure with higher yields via funds such as Artemis Global Income* (GB00B5N99561) and Diverse Income Trust* (DIVI) for small-caps. These switches could be funded by reallocating the investments that you already have in these sectors, as well as by reducing the size of some of the individual Finnish investments and reinvesting the proceeds. Doing this would help to diversify away from the euro, too.

Rachel Winter says:

You're considering AstraZeneca which I do not think is expensive in relation to other large European pharmaceutical companies. It pays a good dividend which it can comfortably afford so has a yield of 4.8 per cent and is experiencing strong growth across its oncology division. You haven't got much in the healthcare sector so it would be a good addition.

I do have concerns about your large holding in Lloyds, which currently accounts for over 30 per cent of your UK equity portfolio. Lloyds is one of my preferred stocks at the moment but I'd be reluctant to add to your holding.

Passive funds or ETFs can be a good low-cost way to access certain markets. I'd go for ones with low annual fees and that buy physical investments, rather than synthetic ETFs that get their exposure to investments via derivatives. I tend to prefer actively managed funds though - there has been a lot of downward pressure on fund fees in recent years, and there are now many active funds that charge less than 1 per cent a year.

The pound has weakened this year due to Brexit (UK exit from the European Union) concerns, so if you value your portfolio in sterling you will have benefited from owning a number of euro-denominated investments. I would recommend diversifying further by adding exposure to other countries, particularly the US.

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** IC Top 100 Fund