Too cautious for retirement?

Chris Dillow, specialist writer, Investors Chronicle

This looks like a well-constructed portfolio for a cautious retired investor. The large holding of inflation-linked bonds is that of someone willing to sacrifice returns to protect their real purchasing power. And the equity portfolio is that of an investor seeking good diversification against stock-specific risk but with a strong bias towards defensives: about half of it is in low-volatility stocks such as the oil majors, pharmaceuticals and – (these days!) Vodafone.

This looks fine. But then you say you're willing to accept medium to high risk investments for growth. There seems to be a conflict between your investment objectives and your actual investments.

Such a conflict is, I suspect, rather common. Can we reconcile this? Up to a point, yes. A big holding of defensives is consistent with growth investing, simply because there's good evidence that defensives are often under-priced (read Chris's comment on this) If your weight in defensives reflects a belief that the defensive anomaly will persist, then it is perfectly reasonable.

There's also a case for risk-tolerant investors holding inflation-proofed bonds. If your pension is a flat-rate annuity, there is a risk that you'll be impoverished if inflation rises unexpectedly. I stress unexpectedly because flat-rate annuities protect you against expected inflation. This is why they are higher, in the early years, than inflation-linked annuities. Although this is a low probability, it would be very nasty. It's quite reasonable to hold protection against the small probability of a big loss, in the same way that you buy insurance against your house burning down.

But are these points really sufficient to close the apparent gap between your investment philosophy and your behaviour? I'm not sure. If your "good separate" pension is an inflation-linked one, then you've already got lots of inflation protection, so do you really want to sacrifice a lot of return to buy extra protection? And while I'm probably a bigger advocate than most of the virtues of defensive stocks, even I am unsure whether such a large weighting in them is wholly warranted.

One question to ask yourself here regards your attitude to under-performance. Even if the defensive anomaly continues, it's likely that your portfolio would under-perform if the market rises a lot. How would you feel about, for example, a 10 per cent gain if the market rises about 20 per cent? If you're relaxed about the prospect, then fine, this would be the case if you're concerned with capital preservation. If, however, you'd kick yourself in such an event you've probably got too many defensives. This would be the case if you are trying to reach a particular target level of wealth, perhaps because you want to buy a fancy car or a new house.

The answer here is purely subjective, the question is a way of ensuring that your portfolio fits your attitude to risk. And if your portfolio doesn't, the obvious thing to do is sell some of your inflation-linked bonds to buy equities.

But which ones? The fact that your only really speculative holdings are two oil explorers suggests that you don't see many good growth stories – perhaps because there aren't any! And there's no point buying individual stocks just for the sake of it.

I can only conclude that, unless you want to increase your overall equity exposure, for example with the purchase of a tracker fund at the expense of inflation protection, there's little you need to do here.

Keith Bowman, equities analyst at Hargreaves Lansdown Stockbrokers says:

We would firstly congratulate the reader on building what appears to be a sizeable and diverse savings pool over and above his day-to-day living requirements. We assume that his normal day-to-day living expenses are currently covered by his pension and that the accumulated savings outlined are not required to pay down a mortgage.

We further assume that a will has been made and any required inheritance tax planning arrangements have been put in place, with existing investments removed from the reaches of the taxman through the use of tax shelters such as individual savings accounts (Isas) where possible.

Within a stocks and shares Isa you pay no capital gains tax and no further tax on any income. The amount you can invest into an Isa each tax year is decided by the government, this tax year's allowance being £11,280.

The reader has a medium to higher risk attitude with the key objective being growth. He says the re-investment of dividends to achieve growth is acceptable. In today's low interest rate environment, more and more investors have begun to appreciate the significance of dividend payments and the returns which reinvestment can bring. The dividend is the portion of corporate profits paid out to shareholders. A company's willingness and ability to pay steady dividends over time, and its power to increase them, provide good clues to its health.

Within the managed fund arena, managers across the UK Equity Income sector concentrate on companies with growing dividends. Many such funds over the longer term have outperformed rivals. Over the last 20 years, the UK Equity Income sector has outperformed the UK All Companies sector by more than 6 per cent, according to Investment Management Association (IMA) figures, although there are no guarantees that this will continue.

Many companies held by the reader are also held by UK Equity Income funds. UK Equity Income funds that we favour at Hargreaves Lansdown include funds such as Invesco Perpetual High Income Fund (also in the reader's portfolio) which regularly hold companies such as GlaxoSmithKline, Vodafone and BAE Systems.

Along with these dividend generating companies, the reader also holds a number of stocks aimed at generating capital growth. Oil exploration companies such as the Falklands Oil & Gas and Bahamas Petroleum Company should be considered as higher risk investments. While such companies can bring significant rewards, their share price volatility is often high, with any disappointing developments potentially accompanied by sharp declines in value.

We also favour several of the other funds he holds. With regard to the Black Rock Gold & General fund, the buoyant gold price over the last couple of years has yet to fully translate into gains for the shares in gold mining companies. In addition, for investors who believe currency debasement in the West has further to run, a modest allocation to a specialist gold mining fund for the long term remains a good option.

Meanwhile, the manager of the Invesco Perpetual Japan Fund currently believes that Japanese companies can continue to benefit from robust economic growth in Asia, while the Invesco Perpetual Corporate Bond Fund, as well as offering exposure to an alternative asset class, continues to be managed by what we believe to be a quality team.

In terms of the investments on the reader's watch list, Standard Life UK Smaller Companies fund provides exposure to a sector which historically has provided attractive long term returns. Its fund manager Harry Nimmo is highly regarded, and he also manages Standard Life Global Smaller Companies fund which would make a diverse alternative.

We have no major concerns with this portfolio although with over 20 different holdings Mr Cooper should remember the important balance between diversity and focus.

IAN COOPER'S PORTFOLIO

Source: Morningstar as at 24 August 2012

Exchange rate of 0.6311 on 24 August 2012