Investor close to retirement needs to diversify

RENE'S PORTFOLIO

Price and value as at 16 October 2013

Note: 1 euro = £0.84

OTHER INVESTMENTS

£200,000 spread across individual savings accounts (Isas) and personal investment plans (Pips) for Rene and his wife, plus his wife's stakeholder pension.

LAST THREE TRADES:

BP (buy), Carclo (buy)

WATCHLIST:

BHP Billiton, Antofagasta, Tesco

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

There's a lot to like about this portfolio. It's well-diversified, but not so much so that it's an unwieldy tracker. It has an intelligently limited use of funds, so you're not losing much in fees. You don't seem to trade too much. And there's a nice defensive bias in your holdings - mitigating the higher-beta exposure to banks - which should exploit the tendency for these to do better than they should over time.

The issue here is: should you be so exposed to equities, given that you're not far off retirement? You say you're willing to assume risk. Let's test this.

Using rough round numbers, I'd assume an expected real return of 5 per cent a year on this portfolio, with a standard deviation of 15 percentage points; I'm calling this lower than the market's volatility, because of its decent diversification and defensive bias. These numbers imply that there's around a one-in-six chance of you losing 10 per cent or more - in real terms - over the next three years.

In fact, the risk is worse than this. The sort of circumstances in which your shares would fall are likely (but not certain) to be circumstances in which bond yields also fall - such as heightened risk aversion and/or weak global economic growth. In such a situation, you face the problem not only of having lower wealth, but of seeing that wealth buy you a smaller annuity.

How concerned should you be by this? It depends upon three things.

First, if things turn nasty, will you be able or willing to work longer to make up for your equity losses? This depends upon idiosyncratic facts: your health, how much you like your job and how safe it is.

Second, how much retirement income do you need? Right now, your portfolio would buy you an income of less than £20,000 a year. If this is sufficient, you don't need to take on so much equity risk. If not, perhaps you do. It's not just your portfolio of stocks you should review. Review also your 'portfolio' of spending habits. If you can't increase your assets, at least try to reduce your liabilities.

Third, remember that risk works both ways. The same maths tells us that there's around a one-in-six chance of your portfolio rising over 40 per cent in real terms. Better still, the circumstances in which this would happen are likely to be ones in which bond yields and hence annuity rates rise - namely, faster economic growth and increased appetite for risk.

The question is: are these considerations sufficient to justify your equity exposure? If they're not, the answer isn't to switch to even more defensive equities. Even the most defensive equities are only relatively defensive; they'd still probably fall if the market takes a dive.

Nor, I suspect, is the answer to hold bond funds. These do have a role, in principle, for people approaching retirement; because they would rise in price if bond yields fall, they provide a hedge against the risk of falling annuity rates. I'd be cautious of these now, however, because I suspect that the central case scenario is for yields to rise over coming years - not that you should base your investment strategy upon my futurology (or anybody else's).

Instead, the only solution is a dull one: to hold more cash - unless you're already doing so in your personal investment plans (Pips) or individual savings account (Isas) - or some specific bonds maturing in three to four years' time. Doing so reduces your returns, but then so does any insurance policy.

Keith Bowman, equity analyst at Hargreaves Lansdown, says:

You sit at a highly important point in your investing career. With retirement on the near horizon, taking the necessary steps to prepare for retirement is hugely significant.

Making sure that investments are held, where possible, within suitable tax wrappers such as self-invested personal pensions (Sipps) or Isas is an important step. Sheltering investments from tax, and in the case of Sipps, potentially gaining the tax relief which the government offers on contributions, is highly worthy of consideration. Utilising each individual's yearly capital gains tax (CGT) allowance for investments held outside of tax wrappers also potentially increases overall tax efficiency - but always consider taking advice from a professional tax adviser before acting.

With only three years until retirement, and contrary to your desire to generate capital growth, we believe capital preservation should form the central plank of your investment strategy. Events such as the banking crisis of 2008 can suddenly reduce the value of an investor's portfolio, leaving little or insufficient time for a subsequent recovery. In general, this would normally mean increasing the proportion of historically less volatile fixed-interest investments held such as government bonds and corporate bonds, and reducing more volatile and historically higher-risk investments such as equities.

However, while this should not be completely dismissed, in the current ultra-low interest rate environment and with fixed interest or bond prices generally moving in the opposite direction to central bank interest rates, additional caution with regards to fixed-interest investments appears warranted. As such, higher dividend-paying shares have become the preferred asset class for many asset managers.

Furthermore, and again with capital preservation and reduced risk central to thinking, you should consider a push for diversity in all its forms across the portfolio - diversity of asset class, diversity within the specific asset class and geographical diversity. With this in mind, you might consider a gradual switch away from some of the individual company equities held and towards diversified funds.

We would also at this stage recommend a bias towards income-generating investments. The income can at this point be rolled back into the investment or accumulated, potentially providing some cautious capital growth, although at a later stage be paid direct to you, with the option of so called 'income drawdown' being considered within a Sipp.

Some funds to consider would include:

HL Multi-Manager Equity & Bond Trust Acc (GB00B1434Z41) is constructed to blend Hargreaves Lansdown's favoured fixed interest and equity managers. The fund pays a historic income yield of over 2.5 per cent on a quarterly basis.

HL Multi-Manager Strategic Bond Trust Acc (GB00B3D4SX81) is constructed to hold our favoured fixed-interest funds. The underlying investments will mainly consist of gilts, foreign government bonds and debt issued by companies listed in the UK and overseas. The fund pays a distribution income yield of over 2 per cent on a quarterly basis.

Artemis Income Acc (GB0032567926) invests in 69 companies, mostly large, well-established UK companies and includes a number of the individual shares currently held by the reader such as Vodafone, BP and Centrica. The fund manager, Adrian Frost, continues to look for companies with healthy cash flows where the long-term potential for dividend growth is strong. The fund pays a historic income yield of over 3.5 per cent.

Newton Global Higher Income GBP Acc (GB00B5VNWP12) is a global income fund which gives investors access to markets that are not readily available to investors such as Brazil or Russian equity income stocks. The overriding objective of the fund is to provide growth in income and capital over time. The fund pays a historic income yield of over 4 per cent.