Young investor has his sights on £1m portfolio

AATIQ SAIQ'S PORTFOLIO

Notes: Data as at 24 April 2013 when €1=0.85p and $1=0.66p

Source: Investors Chronicle and New York Stock Exchange

Last three trades

Lockheed Martin, Philip Morris International and Fidelity Income Fund.

Watchlist

Archer Daniels Midland Co, Bank of America Corp, Boeing Co, CVS Caremark Corp, Caterpillar, Chevron Corporation, Cisco Systems Inc, Citigroup, Coca-Cola Enerprises, Conoco Phillips, Honeywell International, Imperial Tobacco, International Business Machines, Mastercard, Mattel, National Grid, PepsiCo, Pfizer, Royal Dutch Shell, SSE, Stanley Black & Decker, Tesco, Unilever, Union Pacific, UnitedHealth, Walmart Stores and Yum Brands.

Chris Dillow, Investors Chronicle's economist, says:

You are unlikely to reach your goal of accumulating £1m. If we assume an average return of 5 per cent a year on both this portfolio and your savings of £10,000 a year, then in 30 years' time you will be over £250,000 shy of your target.

There are three ways you might hit the target. One would be if we all get lucky and returns are higher than I've assumed. Another would be if inflation raises the nominal value of stocks. This, however, would be no use to you as it would also raise your cost of living, which would mean you will need more than £1m. The third way would be if your income rises over time, allowing you to save more.

Herein lies a key point. For younger people, the way to get rich is to work and save. Unless your asset allocation choices are very strange, they are of secondary importance.

And your choices are not strange. Granted, many people might find it odd that someone so young is holding some 60 per cent in bonds. But I don't; the general principle that younger people should hold more shares than older ones is far more doubtful than folk wisdom suggests.

Instead, there are three issues to consider here.

First, is it wise to have heavy long-term exposure to bonds at this juncture? I suspect that, over the longer term, government bond yields will rise as investors' appetite for risk returns to normal; as quantitative easing ends; as China's savings glut diminishes; and as investors worry more about the effects of an ageing population upon US government debt. This fall in the prices of government bonds would tend to drag down the prices of corporate bonds, unless credit spreads narrow. While this might happen to some degree as the global economy returns to normal, it might not do so sufficiently to offset fully the rise in government yields.

In this sense, although your bond holdings do diversify your equity risk, they do so at the expense of exposing you to a different risk.

The second issue is: will Gibrat's law hold? This is the prediction that corporate growth is uncorrelated with size, so large companies are as likely to grow well as small ones. In holding so many big stocks, you're betting this will be the case.

This is a reasonable bet. Long-term growth is largely a random process. And insofar as your shareholdings comprise a lot of defensive stocks, you should benefit from the well-established tendency for these to do relatively well.

That said, there is a danger in holding even big-name stocks in the long run, because even the largest stocks can get into trouble eventually. For example, 30 years ago the Dow Jones average included companies such as Eastman Kodak, Woolworth, American Can and International Harvester - all of which subsequently hit very hard times. This warns us that there's no guarantee that even blue chips will survive, let alone thrive.

For this reason, I think it's a good idea for properly longer-term investors to hold a tracker fund, as this removes the long-term uncertainty that surrounds even the apparently best individual stocks.

My third issue is that, in holding US stocks you're betting on the continued vigour of the US economy. The problem here is not so much the stocks themselves; any shareholdings are a bet on the US economy, simply because almost all stocks are correlated with the US market. Instead, the problem is the US dollar. If the US economy gets into trouble, or if risk aversion (as distinct from ambiguity aversion) rises, then losses on US stocks could well be accompanied by losses on the US dollar.

Now, this is only a risk; the fact that longer-term bond yields are similar in the UK and US suggests that the market isn't expecting the sterling-dollar rate to change much in the long term. But why take a currency risk you don't need to?

Adrian Lowcock, senior investment manager at Hargreaves Lansdown, says:

A monetary target for a portfolio value is a bit vague; £1m seems like a lot now, in the current climate it would generate an income of around £40,000. But in around 40 years' time, when you are 69, inflation will have eroded the value of £40,000 - ie, £40,000 in 40 years' time will buy you a lot less than it can today. (Inflation of 3 per cent will halve the value of your money in 23.45 years and it will fall to quarter in 46 years).

You should make sure you hold as much of your investments inside tax-efficient wrappers such as stocks and shares individual savings accounts (Isas) or a self-invested personal pension (Sipp). Initially, you may wish to start out with Isas as you can then access the money in an emergency should you need to. The bond funds would be best off inside an Isa wrapper as the income produced would then be received completely free of tax. In the long term, the tax benefits of Isas and Sipps will make a huge difference.

You have over 60 per cent of your portfolio invested in high-yield bonds, close to 35 per cent in US equities and around 2 per cent in the UK and Europe. Bond funds provide a stable income but little opportunity to grow that income. At this stage of your life, I would recommend you take on some risk selling your high-yield bonds in favour of strategic bond exposure, equity income and other global equities. A strategic bond fund gives the manager the greatest flexibility to move across the whole market and find the best opportunities.

Your holdings in individual company shares are too small to have a significant impact on the portfolio. It is very difficult to build up a diversified portfolio of direct equities unless you have a large enough base. It is best to avoid small holdings where transaction costs could have a significant impact on the overall performance. Likewise, it is very hard to get a good spread of different markets and invest in a broad spread of sectors.

You have gone mainly for US large-cap companies with strong brands, but in doing you lack exposure to the rest of the world and certain sectors. Instead, I would suggest you construct a core portfolio of funds from which you can build upon. Initially, you should use fund managers who have a huge amount of experience in investing and are able to hold a broader range of shares. Most managers hold at least 30 stocks (often more) in just one country. That way you can benefit from diversification, learn how the fund is managed and then add individual companies.

Holding around 35 to 40 per cent in UK equities, with 10-15 per cent in each the US and Europe and approximately 15 per cent in bonds, would give you a decent spread across your portfolio across the major asset classes. This would also leave you room to get exposure to other asset classes such as Japan, Asia and emerging markets. Given the size of the portfolio this could be achieved initially through a number of core holdings with some additional exposure through more specialist funds. A good core to consider is a global equity fund such as Newton Global Higher Income, which could be complemented by the Troy Trojan fund. Both would provide a stable base from which to add to through other specialist funds.