Ditch and switch to generate income

"Our aim is to continue to grow the portfolio over the next three years, leading up to my wife's retirement," says Laurence. "The aim would then be to generate an income of 4 per cent following my wife's retirement in 2019 when she becomes eligible for the state pension.

"We would like to live within the income generated by the portfolio, but if necessary will take some capital when required. Our objective is to leave as much as possible for the benefit of our two children and four grandchildren - but without us spending our retirement in penury. We recognise that may be an over ambitious aim as it would require us to live on an income reduced by some 25 per cent, due to the loss of my wife's salary.

"We currently take no income or capital from the portfolio, and my wife continues to save £600 a month into her individual savings account (Isa).

"My attitude to risk is perhaps greater than it should be at this stage in our lives, but it will probably become more conservative once my wife retires in three years. Given the present worldwide economic and political situation there could be a situation when most - if not all - of our investments might be lost.

"I am trying to move away from individual equities into investment trusts and exchange traded funds (ETFs), as and when the opportunities present themselves, with a view to increasing income and reducing costs and charges.

"I try to trade as little as possible at this stage other than re-investing the dividends and income generated.

"I have on my watchlist Aberdeen Asian Income Fund (AAIF) and Scottish Mortgage Investment Trust (SMT).

Laurence and his wife's portfolios

THE BIG PICTURE

Chris Dillow, Investors Chronicle's economist says:

This portfolio looks like that of someone who has been investing for 40 years, in that it is rather sprawling and unmanageable. You're right to want to simplify it, and to shift into investment trusts and ETFs.

In doing so, I suggest you think in terms of top-down asset allocation. It's very easy for investors not to do this and instead adopt a bottom-up approach, via which they buy attractive-looking assets but in doing so end up with a portfolio that doesn't serve their fundamental purposes.

The first question to ask is: what should be my split between risky and safe assets?

But here there is a paradox. On the one hand, you say that it's possible that there'll be a situation in which "most if not all our investments would be lost." This is a very pessimistic view. But it conflicts with your portfolio, which has a very low cash weighting.

So you face the unavoidable trade-off between risk and return. Your objective of a 4 per cent income is perfectly feasible. With zero real returns, this would give you an income of around £16,000 a year. If this is sufficient for your needs, you can afford to forego growth and thus avoid risk. If not, you need to take that risk in the hope of growth.

David Liddell, chief executive of IpsoFacto Investor, says:

Your wife might consider making contributions to her Sipp rather than her Isa, as she would get tax relief and build up a fund which can potentially be passed on to children free of inheritance tax, although your other assets are below the combined limit of £650,000. The contrary argument is you should both watch your income tax position to see if the combination of income from the Sipp and state pension takes you over the personal allowance threshold. In this case you might be better off from an income tax perspective having more money in the Isas or outside any wrapper, where you can get £5,000 of dividends tax free any way.

Your investments are reasonably well diversified and we estimate the underlying yield on your total investments to be around 3.1 per cent.

I think you are on the right lines in terms of your plan to reorganise your investments and sell down the individual equities. But I would prefer to see a bigger cash pile to provide some rainy day funds and give you the ability to take advantage of opportunities as they arise. I realise this sacrifices potential return but it is good to have some diversification. And with government bonds generally very expensive, cash may be the best diversifier.

Ben Yearsley, investment director at Wealth Club, says:

Your key goal is growth for the next three years, then 4 per cent income from the portfolio with some capital growth. Equity income, both from the UK and globally, satisfies both these needs if you are a long-term investor, so should form a big proportion of your portfolios.

Both Isas and Sipps enable tax-free growth, and the Isa also enables free tax-income. Your Isas currently have over £100,000 invested in them, and could easily provide 4 per cent income with the correct asset allocation, with the prospect of some capital growth too.

With just over £700,000 in assets and a good proportion in pensions, inheritance tax shouldn't be much of a problem.

HOW TO IMPROVE THE PORTFOLIO

Chris Dillow says:

You may not be as well diversified as you think, because your property and bond holdings might not spread equity risk. High-yielding bonds might do badly in a recession because investors would fear an increased chance of default. Property too might also suffer. It is only cash and government bonds that are recession-proof. Yes, these have the obvious drawback of low yields. But those low yields reflect the fact that investors are willing to sacrifice lots of return to get insurance against recession and equity risk.

You ask how much should you diversify internationally? Brexit has increased the risk of a localised UK recession, one that could see you lose not just on UK equities - especially smaller and mid-cap ones - but also property and higher-yielding bonds too. I'm not sure this risk is fully priced in. Exposure to overseas equities might offer you some protection against this, especially if sterling falls further, as is likely in the event of disappointing growth.

You should also consider what equity factors you want exposure to. Here you are doing something sensible, as many income investors do, perhaps by accident. You have some defensive holdings not just directly but via investment trusts: Murray Income (MUT), City of London Investment Trust (CTY) and to a lesser extent Temple Bar (TMPL), all have big holdings in large defensive stocks. This is sensible not so much because these protect you from the risk of recession and falling share prices - in such an event they would probably fall too but not as much as the general market - but because such shares tend to outperform on average over the long-run.

These principles suggest your core holdings should be a FTSE All-Share tracker, accompanied by overseas trackers insofar as you want to diversify away from UK risk. If you want some exposure to UK cyclical risk, say because you think economists are wrongly pessimistic, then FTSE 250 and small cap funds give you this.

But please, think about that cash weighting too.

David Liddell says:

If you add together the housebuilding shares, property funds and Spanish property, your property exposure seems too high, although the funds' exposure is largely to commercial property. We have never been that keen on UK commercial property as a diversifier if you already have substantial value in a second home. Although a temporary reaction to exceptional circumstances, we have recently seen how property funds can potentially be illiquid, with some of these suspending withdrawls in the face of falling prices. As you hold property investment trusts this problem does not arise. While now may not be the time to sell it is worth watching.

With only three years till your wife retires you may want to steer the portfolio in the direction of the type of yield you will want at that point. With a Sipp, under new legislation you should be able to draw as much as you like as income, but if you want to preserve capital for your children, the best way to do so is set up your portfolio with the natural yield equivalent to your income requirements.

Your Sipps yield 3.5 per cent and your Isas 2.2 per cent. As well as Aberdeen Asian Income, consider adding JPMorgan Global Emerging Markets Income (JEMI). You could also increase the number of equity income trusts you have in place of some of the lower yielding assets, to help you achieve your desired 4 per cent yield.

Ben Yearsley says:

You said yourself that there are too many holdings - and I agree. It feels like a portfolio that has been built up over time rather than planned. For example, what is the point of having a global equity ETF when you already have three different global holdings as well as regional ones? You should sell iShares Core MSCI World UCITS ETF (SWDA) and top up one of the other global holdings.

Another way of reducing the number of holdings would be to gradually reduce the individual equity weightings - especially in the UK where you have a mix of trackers and direct equities, mainly large-cap ones.

During the recent Brexit wobbles, having overseas equities should have aided the overall portfolio performance as sterling plunged, increasing the value of overseas assets for UK-based investors.

The bond and direct commodity holdings are also useful diversifiers. But as you are still seeking growth I wouldn't increase your bond exposure much further.

With gilts yielding minimal amounts, if you want 4 per cent income you will have to concentrate on high-yielding bond funds. I don't think passive funds are a good way to invest in bonds so I would sell the four fixed income ETFs and add more high yield or strategic bond funds such as Kames High Yield Bond (GB0031425563), Jupiter Strategic Bond (GB00B4T6SD53), Royal London Sterling Extra Yield and Artemis Strategic Bond (GB00BJT0KV40).

Higher-yielding investments should progressively be switched over to the Isas to ensure maximum tax efficiency when taking income in a few years' time.

More income-orientated investments to consider include Perpetual Income and Growth Investment Trust (PLI) and Standard Life Equity Income Trust (SLET). Both offer the prospect of capital growth and a decent yield, so would complement Murray Income and Temple Bar. Maybe consider selling down your direct equity holdings and iShares UK Dividend UCITS ETF (IUKD over time, and adding those two investment trusts in.

You have far too much crossover, especially in terms of your UK investments with about 26 holdings. This could be reduced to below 10 and have the same level of diversity. For example, why do you have two FTSE 250 trackers? I know they are in different portfolios, but you should consider the portfolios as one. You could reduce your FTSE 250 exposure in favour of more large-cap exposure which should be less impacted by Brexit.

I would certainly look to add Aberdeen Asian Income at some point as it has good managers, and offers decent yield in a growth area which has been largely overlooked in recent years.

I would generally look to consolidate the portfolio, for example, by reducing the Japan holdings from three to two, and making sure the holdings are doing different things to each other.