Cut your losses on high exposure to banks

Paul Gorham's portfolio

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

I have accused many readers of being over-diversified. You are certainly not guilty of this. In fact, with three-fifths of this portfolio in three banking stocks, I fear you are under-diversified and are exposed to a lot of risk.

I say this for three reasons.

First, bank stocks are volatile in themselves. To take one measure as a rough guide, the average standard deviation of the three's monthly returns since January 2000 has been around 13 percentage points. This implies that there's a roughly 30 per cent chance of losing 20 per cent over a 12-month period. By contrast, historic volatility suggests there's only a 7 per cent chance of such a loss on GlaxoSmithKline.

Secondly, bank shares are highly correlated with each other, so a loss on one is highly likely to be accompanied by a loss on the others.

Thirdly, bank shares are positively correlated with the other shares you hold. Such correlations imply that if banks do badly in any particular month, there's a more than 50:50 chance that any one of your other shares will also fall.

You are, therefore, putting a lot of eggs in one basket. I was tempted to try to quantify the risk of this. But I fear that the standard maths of portfolio risk doesn't tell the whole story for you, because the risks to this portfolio are asymmetric.

Imagine we were to get good times; the economy recovers and the risk of financial crisis fades. In this world, the upside on Lloyds and RBS would be capped because investors would anticipate the government selling its big stakes, and a big supply is bad for prices. However, if we were to suffer bad times, the losses on banks are not so limited.

So far, so bad. What comforts do we have? If you have some other assets - say, lots of cash in other accounts - things aren't so bad, as such holdings would cushion any losses on this portfolio.

And there is some hope here. Insofar as stock markets are informationally efficient - which they are to some extent - you get what you pay for. This means that if shares carry especially nasty risks, some investors will be avoiding them and so their price should be low enough to reflect this, which should mean their expected returns will be high. I suspect that in this case, the payoff takes the form of a good probability of a decentish return, rather than the smaller chance of a stellar one; the cap imposed by the prospect of privatisation rules this out.

You might find this a comfort. Perhaps too much so. One problem we all have - and not just in investing - is our tendency to indulge in motivated reasoning, or wishful thinking. Once we've taken a position in a share (or on a political issue!), we find reasons to justify it that we would not otherwise consider convincing. A particular aspect of this general phenomenon is what we call the disposition effect - the tendency to cling onto poorly performing shares in the hope they will return to the price we bought them at.

Which brings me to my question. Could it be that the main reason you have so much invested in banks is not that these are good investments now, but that you bought them years ago and have clung onto them in the hope of cutting your losses?

Everybody makes mistakes; it's what humans do. The trick is to learn from our errors, and to ensure that past mistakes don't lead to future losses. Unless you have an unusually high tolerance for risk, I would suggest you reduce your bank holdings. If you want to maintain equity exposure, you could shift into a tracker fund, at least until some more stock-specific ideas occur to you.

Ben Yearsley, head of investment research at Charles Stanley Direct, says:

Your portfolio is very heavily skewed towards Lloyds Banking, which could be inspired... if it ever recovers properly. In addition you say that you are new to investing and unsure, but then say you have been investing for 10 years with a portfolio of just eight shares. There are a few contradictions in here.

You have a few clear goals in mind. You want to be able to repay your mortgage, fund your children's university career and pay for holidays. So a mix of long- and short-term goals, however mainly long term (if you ignore the holiday request).

I don't think eight shares with three of those banks is a properly thought through portfolio. In addition, you have a large part of your portfolio invested in Lloyds Banking (and a few other banks) - which you readily admit is your biggest mistake. You bought them prior to the banking crisis, and assuming you are sitting now on a large loss, I think you need to be realistic and realise that you will not make your money back on either Lloyds or RBS. However, if you want banks, why not concentrate your exposure to the sector in HSBC (HSBA), which is a much more blue-chip name?

Turning to your other shares, the ones I like are J Sainsbury (SBRY) and Vodafone (VOD). Sainsbury is doing a good job of making up for anaemic like-for-like growth (due to tight household budgets) by expanding its convenience format and online distribution, particularly in the north of England where it is a bit under-represented. Vodafone has been buoyed up by speculation about the sale of its Verizon Wireless stake, but that has tended to obscure improvement in the underlying business, where recent margin contraction has probably run its course.

I'd question the merit of holding ITV. It went ex a special dividend at the beginning of this month, and to see scope for capital growth you have to be optimistic about the outlook for TV advertising, even as the internet gives advertisers more and more alternatives for their advertising spend.

The shares you hold are all quite mature companies, and although the banks might deliver recovery growth, they really already have. Why not look at some of the low-profile engineering sector companies that are trading well and talking confidently at the moment eg, Babcock, Weir, Melrose.

I think you need to take a new approach to your investments. If you just want shares, and not funds in your portfolio, then I would suggest a portfolio of at least 20 shares, but to go down this approach you need to have the time to commit to monitoring their progress. If you don't have the time, then funds may be a better alternative. The second thing you have to appreciate is that in order to diversify you will have to crystallise some losses on your existing portfolio - unless you have new capital to commit to the markets.

Maybe the approach you should take is to have a core of funds and then have a periphery of direct shares to add some spice and some areas of interest. Obviously, be wary of doubling up exposures. I would always look for a solid core of funds; maybe equity income - interestingly many of your direct holdings are staples of many equity income funds. So have a core of these funds such as JOHCM UK Equity Income (GB00B03KR831) or to get some overseas core exposure via a fund such as Aberdeen World Growth & Income (GB00B4LD9312).

However, you do have a long-term horizon, at least eight years, so can afford to take increased risk, even though you are a new-ish investor (you must have been investing for at least five years already). Therefore it makes sense adding in riskier funds, maybe some European exposure through a fund such as Jupiter European (GB0006664683), or US through Legg Mason US Smaller Companies (GB00B6YRLS30).

You mention you would like some Chinese exposure, this can be achieved in one of three ways; an emerging markets fund, an Asian fund, or a Chinese fund. A fund such as Aberdeen Global Chinese Equity (LU0837970457) is a decent place to start.

To sum up I think you need a rethink and a rebalance of your portfolio. You have made some mistakes that have cost you, especially in banking shares. You need more diversification, either through the addition of more shares into the portfolio or by using funds in addition to shares.