Long-term investor embraces volatility

COLIN LAMBERT'S PORTFOLIO

LAST THREE TRADES

Berkely (Buy), Carillion (Buy) and Rio Tinto (Buy)

WATCHLIST

Rolls Royce, Lloyds Banking, VCTs

Chris Dillow, the Investors Chronicle's economist, says:

There are two big things I like about this portfolio. One is your scepticism about funds. This is correct, in the sense that there's little point paying high fees for a manager's expertise which is very often illusory. The case for buying funds is to get easy access to a diversified asset class that would otherwise be tricky to obtain. This is just what you're doing with your smaller companies and emerging markets investment trusts, and with your US tracker.

Another thing I like is the defensive bias among your shareholdings. This gives you good exposure to one of the best-attested stock market anomalies, the tendency for lower-risk stocks to outperform on average over the long run.

I'm also relaxed about your heavy equity exposure. Granted, it would be too big for me. But that's because I'm the nervous sort. Ultimately, the question of how much equity exposure you have is a matter of taste. Certainly, the mere fact that 76 years old is no reason to trim your holdings; the idea that older people should own fewer stocks than young ones is deeply questionable.

There's one point where I half agree with you - when you say you want to avoid bonds as they are heading for a loss. I agree that, especially over the longer run, government bond prices are likely to fall. The question is: how much weight to put upon this? No view of the future can be anything other than uncertain, and the point of diversification is to protect us from our ignorance.

How far this gives us a case for holding bonds depends, in part, upon the validity of something else you say - that you don't equate volatility with risk.

In one sense, this is very intelligent. If you are a genuine long-term investor (and only some of those who claim to be actually are), then some volatility doesn't matter. If you're holding shares for, say, five years, their day-to-day fluctuations are to a large extent irrelevant. Granted, a share price's fall might be a sign of worse to come - if, for example, one profit warning leads to others - in which case you should respond to near-term volatility. But I suspect that, as often as not, the attempt to do this will merely cause you to sell at the bottom. If so, paying attention to near-term volatility can be positively dangerous.

If you are this type of investor, then I can see why you might avoid bonds. Yes, they very often protect us against the sort of falls in shares that are caused by an increase in investors' risk aversion. But if you look through these falls, the case for buying expensive protection against such falls is indeed weak.

However, we should not dissociate risk and volatility entirely, because volatility gives us a decent measure of the risk of a fall in share prices over the longer term.

Let's quantify this. Let's say your equity holdings will give an average real return of 5 per cent per year, with annualised volatility (the standard deviation of returns) of 17 per cent; this is slightly less than the All-Share's long-term volatility, reflecting your defensive bias. Now, if returns are uncorrelated from one year to the next - and aggregate market returns have been - then the standard deviation rises with the square root of time. So the standard deviation of 10-year returns is 17 multiplied by the square root of 10, which gives us 53.7. The expected return on this portfolio over 10 years is 5 per cent compounded, which gives us 62.9 per cent. The chance of a real loss over 10 years is therefore a 1.17 standard deviation event (62.9 divided by 53.7), which a normal distribution table tells us is 12.1 per cent. Call it a one-in-eight chance.

Now, you cite the example of GlaxoSmithKline as a case where volatility has been of no consequence. But this is a horrible example of selection bias. What other stocks did you buy 35 years ago? A few, I suspect, that haven't done so well. Stock market history confirms what my abstract calculation tells us - that there have been 10-year periods of real losses such as in the 10 years to 1909, 1920 or to the late 1970s.

I don't say this to mean that you are wrong. You might well think that a one-in-eight chance of a loss is fair recompense for a better-than-evens chance of a 50 per cent real gain. Just be clear that there is risk, and 'volatility' - with a little manipulation - can help us measure it.

Helal Miah, investment research analyst at The Share Centre, says:

Your key investment criteria is to supplement your pension income and preserve capital to leave to your grandchildren. I believe the portfolio's balance towards blue-chip, defensive high-yielding stocks such as pharmacueticals, food retailers, utilities and household goods supports this objective.

The portfolio is relatively wel- diversified in terms of individual shares and spread of sectors. The largest holding in the portfolio is GlaxoSmithKline, making up 12 per cent, and in fact the pharmaceutical sector is the largest sector allocation. GlaxoSmithKline is a company we have liked as a lower-risk investment for a long time as it has a strong cash flow and pays a solid dividend. Among the larger-cap pharmaceuticals, it has a promising drugs pipeline, while others are fighting against patent expiries and generic competition. However, as GlaxoSmithKline makes up a large proportion of the portfolio and has performed very well lately, we would recommend you to realise some of your profits in the company and take your weighting down marginally to reduce risk.

You have a lot of exposure to the housebuilders through your holdings in Taylor Wimpey and Berkeley Group. The companies have performed very strongly and we believe the sector as a whole has more growth potential. The UK is short of housing and government policy will be favourable to try and get a recovery going. This is one of the key growth exposures for your portfolio.

A good, well-balanced portfolio does need some exposure to international equities and small caps. The four managed funds that you invest in give you exposure to the US market, global smaller companies and the emerging markets. These represent roughly 20 per cent of the portfolio, which I think is an appropriate proportion.

The portfolio looks to be generating a yield of 3.5 per cent. I have included the large cash balance (16 per cent of the portfolio) in this calculation for which I assume it is generating a fair 1 per cent yield. To improve the total yield of the portfolio, you could invest more of the cash balance in other large income or balanced companies.

The portfolio is probably underweight in oil and gas producers, as you only hold BP which makes up just 2.7 per cent. Topping up in this sector by buying into the large caps such as Royal Dutch Shell 'B' would certainly boost the yield. Some exposure to the blue-chip insurance companies would also help increase the income potential on the portfolio as you have no holdings in this sector.

You are also underweight in the mining sector, with Rio Tinto accounting for 2.5 per cent. Although this will have benefited you recently, as the sector has been weak during 2012 and so far in 2013, we believe there is good value in the sector. Increasing your exposure to another large-cap diversified miner could pay rewards in the long term, especially when you consider that some large miners now pay a yield in excess of 4 per cent such as BHP Billiton.

I disagree with your views about risk. Although holding companies for the longer term does mean you may be able to ride out the volatility, it doesn't mean that you eliminate the risk. If you take Lloyds Bank, for example; investors that bought into the company before the financial crisis are very unlikely to be back in the black any time soon. Investors should always be aware that the value of an investment can go down as well as up and be willing to accept the level of risk associated with each holding.