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Building up a home deposit and long-term savings

Funds, Isas and low charges are the key to success for this young investor
December 29, 2016

Chris is 26 and has a full-time job that pays £26,000 a year. He is single and doesn't have any dependants. He pays a modest rent as he lives with family. He is looking to purchase his first home in the north-west and has been investing for 18 months.

Reader Portfolio
Chris Phillips 26
Description

Funds held in Isa

Objectives

Growth over 10 to 15 years

"I want to beat the interest rates you get on savings accounts, at least in the short term," says Chris. "I do not yet have any plans for using my investments for retirement, but I want to maximise the potential of my finances and achieve significant growth over the next 10 to 15 years.

"I also have £15,363 in a cash individual savings account (Isa) that pays 1 per cent annual interest and have been paying up to £1,000 a month into a regular savings account that offers 2 per cent annual interest, but this closed at the end of December. I am now considering the Lifetime Isa, which would go towards a deposit to help fund a house purchase.

"I am not averse to risk, and in the past year at one point I lost around 20 per cent of my overall portfolio value, but have been through the troughs.

"My first job after leaving university was working for a small financial planning business which gave me direct exposure to the processes involved in managing portfolios - primarily pensions. I have picked up some good principles: I saw the effect of diversifying investments, and the effect that attitude to investment risk has to maximise potential gains or provide better financial security.

"Last year I had a large boost to my finances of £60,000 due to inheritance. I spent £12,000 of that on studying for a masters degree and put the remaining money into a cash Isa, a regular savings account, and an investment Isa. At the start of the current tax year in April 2016 I again put the maximum limit into the investment Isa.

"I am keeping the cash Isa reserve as my deposit for purchasing a home and I am adding £1,000 each month to it. By the end of the year this should be £23,000, hence I take a riskier stance with the investment Isa given that around two-fifths of my total assets are cash. I assigned myself a risk score of 8/10 and constructed a portfolio with weightings to reflect this. I will revise my finances every six to 12 months.

"I'm not interested in buying shares in individual companies so my portfolio is completely fund-based. I have chosen funds that meet at least one of: a good Morningstar rating; a small annual management or ongoing charge - a reason why I favour Vanguard funds in particular; or have consistently outperformed their benchmark.

"Although I have made money on my current holdings I am 99 per cent sure I have missed some aspects of portfolio building that could enhance the performance. I feel that getting this right now is even more important, given my age, as any negative effects are going to compound over the long run.

"The vote for Brexit this year concerns me. Surprisingly, my investments benefited in the initial aftermath of the vote, but I'm aware that my portfolio could equally be vulnerable over the next few years with Donald Trump's election as US president, and as the European Union divorce proceedings progress.

"My last trades were selling Royal London Corporate Bond (GB00B3MBXC47) due to poor performance and buying Vanguard UK Long Duration Gilt Index (GB00B4M89245) as a cheaper alternative, and selling Legal & General UK Property (GB00BK35DV33) to top up my house deposit fund."

 

Chris's portfolio

HoldingValue (£) % of portfolio
Baillie Gifford Japanese (GB0006011133) 1,473.674.91
Henderson China Opportunities (GB00B5T7PM36)3,302.0110.99
Henderson UK Smaller Companies (GB0007447625)1,733.475.77
Jupiter European (GB00B5STJW84)2,904.429.67
Legal & General Pacific Index Trust (GB00B0CNGY27)2,064.586.87
Vanguard FTSE UK Equity Income Index (GB00B59G4H82)7,560.7825.17
Vanguard UK Long Duration Gilt Index (GB00B4M89245)4,533.1815.09
Vanguard US Equity Index (GB00B5B71Q71)6,405.0321.32
Cash61.420.2
Total30,038.56

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

 

THE BIG PICTURE

Chris Dillow, Investors Chronicle's economist, says:

You are doing a lot right here. You've started investing young, which means you should benefit from compounding returns, the most powerful friend the investor has.

It's a good idea to contribute to the lifetime Isa. This gets you free money from the government: each £,000 you put in every year gets you a gift of £1,000. Be careful to keep an eye on the rules for withdrawing this, though.

And you are absolutely right to pay close attention to funds' charges. Just as returns compound nicely over time, so funds' fees compound horribly. Simple maths shows this.

According to the Financial Conduct Authority, if equities return an average of 5 per cent a year - a reasonable expectation after inflation - then £1,000 invested in a passive fund that charges 0.15 per cent a year will grow to £2,579 after 20 years. But the same £1,000 invested in an active fund charging 0.9 per cent a year will grow to only £2,234. This means that every £1,000 you invest hands £345 to the fund manager over the long haul.

You're probably right to save for a deposit in cash rather than equities. The danger with the latter is that a fall in the market might deprive you of the chance of getting a nice house, whereas with cash you have a much clearer, albeit lower, idea of what your deposit will be.

Reviewing your investments only occasionally is a good idea. Most short-term fluctuations in the market are noise rather than signal and so should be ignored. Paying attention to those risks means you might chase bandwagons rather than good investment opportunities.

 

Patrick Connolly, certified financial planner at Chase de Vere, says:

You understand the benefits of investing in stocks and shares to achieve long-term growth, have realistic targets, accept short-term market falls and are looking to achieve diversification in your portfolio.

As you are young and have time on your side, you can afford to take investment risk. However, you should also continue to use cash savings for your shorter-term goal of building a sufficient mortgage deposit. You have the option of using some of your investment portfolio to reduce your mortgage when you do buy a property.

Saving with a Lifetime Isa, which should be available from next April, is a good idea. You can benefit from a government bonus of 25 per cent on contributions of up to £4,000 a year. However, you can only withdraw cash to buy your first home if you have held the Lifetime Isa for at least 12 months. It therefore won't help if you are planning to buy a property before April 2018. If this is the case you could consider a Help to Buy Isa instead.

Lauren Peters, chartered financial planner at Helm Godfrey, says:

The longer you are able to invest for, the more likely it is that you will generate higher returns so, by getting started while you're in your twenties, you're giving yourself a fantastic opportunity to build wealth for your future.

You're saving for a house, so if you haven't done so already, have a look at properties on the market and work out how much you need for a deposit. It might also be worth speaking to a mortgage adviser to help you understand how much you can borrow, as you need to factor in other property-related costs such as stamp duty, solicitor's fees, removal fees and survey costs.

Once you have a figure in mind for the property purchase, you may want to keep earmarked savings relatively safe. You recently sold a fund in order to boost your house deposit but this is not an ideal way to do it, particularly if you were forced to sell an investment at a lower price than you paid for it.

The Lifetime Isa will be available from April 2017, with the opportunity for individuals aged 18 to 40 to save up to £4,000 a year and receive a 25 per cent bonus from the Government. £4,000 a year isn't a huge amount to save, considering that you are currently saving £1,000 a month, and the 25 per cent uplift is guaranteed and risk-free. But be aware that the bonus is lost if the money is withdrawn before age 60 or not used to purchase a property for the first time.

I assume your cash Isa is your emergency fund. It's essential to have enough money in cash to cover emergencies, but you could probably achieve a higher return on your cash with a current account that pays interest on balances. Plus, as a basic rate taxpayer, you can receive up to £1,000 a year in tax-free interest.

It's good that you are investing within a tax wrapper, such as a stocks and shares Isa. This will ensure returns are received free from income tax and capital gains tax. You have an annual dividend allowance of £5,000 a year and an annual capital gains allowance of £11,100 a year, so using a tax wrapper for investments is less of an issue now, but more important as the fund builds over the years.

Also don't forget to contribute to your work pension as you will benefit from employer contributions and tax relief.

I like that you have risk profiled yourself and constructed a portfolio to reflect that risk rating. However, you swapped out a corporate bond fund for a long duration Gilt fund. These two funds are not the same thing and have different risk and expected return levels.

When reviewing your portfolio, if you are simply comparing past performance of your funds against other available funds, you may end up selling at the wrong time. It's tempting to sell a fund after a short period of poor performance rather than examining the fundamentals, but past performance should not be viewed as a guide to future performance and there is a risk that you will end up selling a fund at a low point in the market, crystallising your losses.

The most important aspect of portfolio building, over the longer term, is making sure you get the asset allocation right and that this reflects your timescale, objectives and attitude to risk.

 

HOW TO IMPROVE THE PORTFOLIO

Chris Dillow says:

Young people are right to prefer funds to individual stocks. Over the long run, even apparent blue-chip companies have a significant risk of collapsing. This is the mark of a healthy economy in which competition is fierce. But holding funds saves you from this risk as with these you back the field rather than any individual horse.

Your portfolio is well-diversified internationally, but this doesn't protect you from general market downturns caused by, say, bad US economic policy, slower growth or heightened risk aversion. National stock markets are highly correlated with each other in the shorter term: they rise and fall together. You can't avoid this by spreading risk across countries.

But international diversification does protect you against the risk that the UK suffers slower long-term growth than other countries - whether because of Brexit or anything else. This is an especially nasty danger for a younger person because such long-term weakness would hurt your job prospects as well as your UK equities.

You are spreading risk by holding gilts as well as equities. Again, though, be clear what this does and doesn't do. Gilts help to protect from cyclical economic downturns and falls in investors' appetite for risk. But they are less helpful in protecting us from things that depress both output and inflation - such as rising oil prices or the sort of protectionism Donald Trump is threatening. They also don't protect us from the danger of rising interest rates.

But cash does, so a smallish holding of this is a good idea.

You say you're 99 per cent sure you've missed something. You're right in the sense that there are many assets you don't hold that will do well. But we can't know what these are because our foresight is limited. What you've got mostly right is a decent asset allocation at a lowish cost. So stop worrying about your investments and get on with your life.

 

Patrick Connolly says:

You are taking a logical approach with your investment Isa in that you are looking for low-cost funds and consistent outperformers, and reviewing it every six to 12 months.

Your equity asset allocation is good. However, while China is a dominant force in emerging markets, I would prefer to spread risks by investing in a broader emerging markets fund such as JPMorgan Emerging Markets (GB00B1YX4S73) or Somerset Emerging Markets Dividend Growth (GB00B4Q07115), rather than a specialist Chinese fund.

In terms of diversification away from equity markets I think there are better options than Vanguard UK Long Duration Gilt Index fund. This has fallen 13 per cent over the past three months following a very strong performance period. It can be difficult psychologically to sell a fund after it has fallen, but long-duration funds are most at risk of capital losses if interest rates in general start to rise.

Many fixed-interest assets look expensive. If investing in this asset class it is probably better to pick flexible funds with experienced managers even if they are more expensive than Vanguard UK Long Duration Gilt Index. Funds to consider include Jupiter Strategic Bond (GB00B4T6SD53), Fidelity Strategic Bond (GB00BCRWZS59) and Rathbone Ethical Bond (GB00B77DQT14).

You could also look at absolute-return funds. Many funds in this sector have charged too much and delivered too little. However, there are some good options, such as Aviva Investors Multi Strategy Target Return fund (GB00BMJ6DT26).

Suggested funds performance

Fund/benchmarkYield (%)1 year total return (%) 3 year cumulative total return (%)5 year cumulative total return (%)Ongoing charge (%)
JPMorgan Emerging Markets  1.05 33.624.637.31.18
MI Somerset Emerging Markets Dividend Growth1.9828.628.650.11.31
MSCI Emerging Markets index NR GBP33.022.535.6
IA Global Emerging Markets sector average30.921.936.9
Jupiter Strategic Bond 4.166.713.541.70.73
Fidelity Strategic Bond 3.215.013.829.90.66
Rathbone Ethical Bond 4.215.819.648.50.69
IA £ Corporate Bond sector average6.917.334.9
IA £ Strategic Bond sector average5.912.531.7
Markit iBoxx GBP NonGilts index TR 8.322.541.2
BBgBarc Global Aggregate index TR GBP21.530.027.1
Aviva Investors Multi-Strategy Target Return0.510.8NANA0.85
FTSE All-Share index TR GBP18.420.063.9

Source: Morningstar

Performance data as at 20/12/2016