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Overseas equity and fixed income could help meet your target

Adding fixed income and overseas equity could help our reader achieve his goal of 3-4 per cent income a year
August 11, 2016, James Norrington & Anna Sofat

Anthony Davies is 84 and has been investing in the stock market since 1953. He is aiming to maintain an income return of about 3 per cent to 4 per cent a year from his main portfolio because he and his wife rely on this income.

Reader Portfolio
Anthony Davies 84
Description

Isas & trading accounts

Objectives

3-4% income a year

He also receives a weekly state pension of £126.54, plus an income from Equitable Life of £369 a month. He has about £8,000 cash in a bank deposit and his wife has a cash individual savings account (Isa) of £11,000.

"We reinvest the income from my stocks-and-shares Isa, and my wife's share portfolio," he says. "The accumulation of income in these two portfolios is to provide funds for possible end-of-life care - my wife is older than I am.

"In terms of my attitude to risk I take the ups and downs in my stride. I try to avoid losses, but sometimes through error in judgment I incur a loss. I should not wish to establish a ceiling for the quantity of loss in any one year.

"I read a variety of papers and magazines, which will sometimes prompt me to consider a particular share, sometimes with a very beneficial result.

"My most recent trades were sales of Royal Dutch Shell (RDSB) and Lookers (LOOK), which resulted in a loss, and the sale of Senior (SNR) which made me a handsome profit.

 

Anthony's and his wife's portfolios

HoldingValue (£)% of portfolio
Trading account
Atkins (WS) (ATK)29,0803.37
BAE Systems (BA.)26,4003.06
Berendsen (BRSN)25,3402.93
Bunzl (BNZL)35,204.254.07
Croda International (CRDA)19,8662.3
EMIS (EMIS)15,2251.76
GlaxoSmithKline (GSK)34,0803.94
iShares Core £ Corporate Bond UCITS ETF (SLXX)29,6163.43
Laird (LRD)19,2272.22
Marston's (MARS)13,9101.61
National Grid (NG.)26,0043.01
Primary Health Properties (PHP)11,4001.32
RPC (RPC)40,756.84.72
Scottish Mortgage Investment Trust (SMT)29,7903.45
Travis Perkins (TPK)21,7422.52
Unilever (ULVR)43,9005.08
Cash38,4734.45
Wife's trading account
BT (BT.A)28,696.53.32
Diageo (DGE)21,7052.51
Dixons Carphone (DC.)11,9981.39
Essentra (ESNT)9,4381.09
iShares FTSE 250 UCITS ETF (MIDD)22,106.252.56
Legal & General (LGEN)20,9002.42
Restaurant Group (RTN)6,9380.8
Scottish Mortgage Investment Trust (SMT)23,8162.76
Unilever (ULVR)42,2044.88
Witan Investment Trust (WTAN)24,3602.82
Cash10,2841.19
Isa
Ashtead (AHT)11,7601.36
Booker (BOK)17,5002.03
Britvic (BVIC)12,357.61.43
Churchill China (CHH)19,1252.21
GKN (GKN)8,7811.02
Imperial Brands (IMB)24,2342.8
Informa (INF)4,9910.58
Interserve (IRV)8,737.51.01
iShares UK Dividend UCITS ETF (IUKD)8,2650.96
Prudential (PRU)16,220.161.88
Senior (SNR)8,6601
DS Smith (SMDS)19,3852.24
Whitbread (WTB)15,5321.8
Cash6,1290.71
Total864,137

Source: Investors Chronicle.

Values as at 4 August 2016

  

THE BIG PICTURE

Chris Dillow, Investors Chronicle's economist, says:

There isn't much wrong with this portfolio. It's well-diversified and has a good weighting in defensive shares such as Unilever (ULV), National Grid (NG.) and GlaxoSmithKline (GSK). This matters, because history and theory tell us that defensives on average tend to beat the market over the longer term.

And you've avoided a common mistake made by many income investors - chasing higher-yielding stocks. Doing this can be dangerous because some high yields, for example those of cyclical shares, are only a reward for taking on extra risk. What matters is total return: capital gains plus dividends. You can create your own dividends simply by selling some shares. And doing so is often tax-advantageous as you can offset it against your capital gains tax allowance.

You say that "sometimes through my errors of judgment I incur a loss", but this worries me for two reasons. One is that losses are sometimes unavoidable, either because the general market falls, usually dragging down most stocks, or because individual shares sometimes suffer due to unpredictable bad news.

What's more, even in the most rational people, errors of judgment are sometimes unavoidable. We are not, and cannot be, desiccated calculating machines.

You should not beat yourself up when you suffer the occasional loss. By all means ask whether you did make a genuine mistake from which you can learn: there's a long list of cognitive errors against which you can check your decisions. But try to avoid the outcome bias: not all failures are evidence of folly, any more than successes are proof of genius.

Thinking of losses as mistakes can seriously damage investment performance, causing investors to hold on to losing stocks because selling would mean admitting they were wrong. This, however, exposes them to adverse momentum effects - the tendency for losing stocks to continue underperforming. Remember to cut your losses.

  

James Norrington, specialist writer at Investors Chronicle, says:

You began investing in 1953, just a year after Harry Markowitz published his groundbreaking work on Modern Portfolio Theory and only four years after Benjamin Graham's The Intelligent Investor first hit the shelves. An important part of investing is finding a style that suits you, something you appear to have achieved a long time ago. With this in mind, there seems little point in making wholesale changes as you seem to understand the risks you are taking and, by and large, are comfortable with them.

Assuming you own your home, your regular outgoings are partly covered by the state pension and your Equitable Life income. Sensibly, you have a sum of cash on deposit for unexpected expenses, and other cash available in your wife's Isa and your investment portfolios. This insurance is important as it means you have the capacity to take on the risk of investing in equities, enabling you to pursue your objective of 3-4 per cent annual income.

Although you are experienced and understand the downside of investing in shares, it is still worth trying to quantify this risk. Value at risk (VaR) is one established technique for estimating the average size of loss you may experience and how likely this is.

But the problem with VaR is that it assigns too low a probability to significant losses that are actually not uncommon, due to its flawed assumption that asset returns are normally distributed. Recognising this deficiency, US firm PrairieSmarts has developed proprietary software to estimate likely losses based on the probability of empirically observed returns.

Looking at the values of your main portfolio (as at 30 June ), a VaR assessment suggests that in no more than 0.5 per cent of months you might lose £46,000 on average. The PrairieSmarts analysis gives a far more conservative estimate of losing £83,000, on average, in such a really unlucky month. If you're not selling the shares, and you have enough income and capital reserves, you can ride out such a trough. But it is always worth having the best understanding of what might happen in a severe crash.

If you are uncomfortable about having to absorb a loss of such magnitude, then to diversify away some of the risk you could invest more in what have traditionally been safer assets such as government bonds. Given yields are at historic lows and your objective for the main portfolio is income, if you are happy with the risks, you might decide not to adjust your existing approach.

It is good that you are considering the possibility of care needs. Capital protection is always important, but perhaps more so for the Isas, given the objective. The Isa holdings are solid companies that pay good dividends, but as you move closer to your 90s, it may be worth switching more of these into lower-risk money market instruments and government bonds.

That said, with inflation likely to outpace returns on these assets, if you are in good health now you could keep a decent proportion in defensive and income stocks. I would suggest you seek further professional advice on funding care.

  

Anna Sofat, managing director of Addidi, says:

Over 90 per cent of your portfolio is invested in equities and as such is high risk. Over the longer term the portfolio will benefit from inflation plus returns, but over the shorter term it will experience high levels of volatility. During the credit crisis in 2007-08, this portfolio would have seen falls in region of 40 per cent.

You say you are not worried about the ups and downs in the market, but given your age I would argue that you no longer have the luxury of time on your side. It could take up to five years for the portfolios to recover from another credit crisis which would take you to almost age 90.

So I would strongly advise you to consider the three dimensions of risk. These are:

1. Your emotional capacity for risk.

2. The level of risk you can afford to take, which depends on the level of cash buffer you have and the life expectation you consider you have. You do not have time on your side as you get older for market volatility.

3. The return you need from the dividend stream is about 3 per cent. Given an overall portfolio of about £860,000, I don't think it needs to be more than 90 per cent invested in equities to meet your need for income and capital for long-term care.

You need to decide if such a high level of risk is desirable or necessary. I would argue that it is not on both counts and suggest you derisk it considerably. My preference would be for more defensive holdings - a mix of cash and short-dated, high-quality bonds.

 

HOW TO IMPROVE THE PORTFOLIO

Chris Dillow says:

This portfolio seems very domestically oriented: with the exceptions of Scottish Mortgage Investment Trust (SMT), Witan (WTAN) and a few multinationals, it has little overseas exposure.

Usually, this is no big deal: even the most parochial UK stocks tend to rise and fall with the global market because shares are substitutes for each other. But it might matter in the next few months. Most economists agree that the UK economy is going to grow more slowly than the world economy, and might not grow at all for a while.

I don't think this prospect is fully priced in because investors don't fully anticipate that a weaker economy will reduce their appetite for risky assets. This poses the risk that UK stocks, and especially the more domestically oriented ones, might underperform the rest of the world. You might want to mitigate this risk by increasing overseas exposure via a global index tracker fund. Or look out for some general overseas investment trusts on a wider than usual discount to net asset value as this can be a sign that the trust is underpriced.

  

James Norrington says:

With income your main goal, the quality and cover of dividends is crucial. For the most part, these companies have positive net cash flows and many have shown a propensity to grow the dividend. To assess whether the growth in payouts is sustainable, check if the dividend is covered by free cash flow rather than just earnings, which can be manipulated by non-cash reporting items such as receivables and inventory.

Loss of income if dividends were cut in a recession is probably a concern for you, so your exposure to corporate bonds is sensible. This may be worth adding to as they are obliged to pay a coupon, although yields are under pressure for good-quality corporate debt. The exchange traded fund (ETF) you have chosen is a good vehicle as you will benefit from capital gains when yields fall. But you should remember that income could fall as lower yielding bonds are added to the fund to replace maturing stock.

Preference shares guarantee a bit more of that regular income stream; however, their yields tend to be lower than those of ordinary shares.

 

Anna Sofat says:

You need to think about the structure of your portfolio, for example, the split between large caps, small caps and value; and the UK and the rest of the world. While the portfolio is well diversified between various sectors, approaching 90 per cent is invested in UK-based shares. Over the past year, the UK has underperformed in comparison with rest of the developed world, although more recently the fall in sterling has resulted in a recovery for the FTSE 100.

You should also consider the suitability of holding individual shares versus collective funds. You have a couple of investment trusts that provide some diversification, but you could improve diversification and generate income using ETFs or managed funds. I particularly like Vanguard FTSE All-World High Dividend Yield UCITS ETF (VHYL), which invests in over 1,100 shares across the world and has a dividend yield of around 3 per cent.