Isa portfolio needs to use the 80-20 rule

KENNY'S ISA PORTFOLIO

Source: Investors Chronicle. Price and value as at 6 November 2013. *1 USD = 0.62 GBP

LAST THREE TRADES:

Communisis (buy), ETFS Physical Gold (buy), Huntsworth (buy)

WATCHLIST:

Dragon Oil, Xchanging, Rio Tinto

Chris Dillow, the Investors Chronicle's economist says:

I've got some good news for you and some bad.

The good news is that this portfolio could well grow to your target of £200,000 in 17 years' time. Annual growth of 7.5 per cent would get you there, which is feasible if you reinvest dividends; over the last 20 years, for example, the market has returned 7.7 per cent per year.

The bad news is that this calculation ignores inflation. Yes, you could get £200,000 in 2030. But it’ll buy you a lot less than £200,000 will buy you today - only two-thirds as much, if we assume 2.5 per cent inflation. If we assume a real return of 5 per cent per year, the equity and fund portion of your portfolio will probably grow to around £140,000 in 17 years' time. And there's probably only around a one-in-five chance of it doing so well as to get to £200,000 in today's prices.

There’s more bad news. I'm not sure that long-term investors should hold specific stocks. This is because, over the long-run unforeseeable creative destruction can kill off what seem like good stocks today. For example, if we assume that the chances of a company failing in any one year is 1 per cent - a pretty cautious assumption - then over 17 years there's a 70 per cent chance that at least one of your seven stocks will be wiped out. If you doubt this, think back 17 years to 1996. The FTSE 100 then contained Hanson, Railtrack and Courtaulds, among others.

You are mitigating this problem by using funds. This is wise. Over the long-run, it’s better to back the field than any particular horse - which is one reason why I'm a fan of tracker funds. Sadly, though, these don't offer the satisfaction and interest that individual stock picks do. There's a trade-off between the cheapest and least risky long-term investment policy, and the more satisfying alternatives.

There is, though, some good news here. You've got a massive asset that'll be the envy of many readers: time.

This is an asset in two ways. First, the fact that you have many years - I hope - in which to earn money helps to protect you from stock market losses, because you can recoup some of these by working, earning and saving. Retired folk don't have this insurance against equity losses.

In this context, the fact that so many of your fund investments are in overseas equities is sensible. For most investors, overseas diversification makes little difference simply because stock markets usually rise and fall together. However, there is a very slight chance that the UK economy could suffer localised troubles, which would hurt both workers and investors in UK stocks; think of the fate that befell Japan in the 1990s. Investing overseas helps protect you from this.

Secondly, you've got time to save more. This makes a big difference. If you can save an extra £1,000 per year - less than £20 per week - then you can make £26,000 over 17 years in today's money (assuming a real return of 5 per cent per year).

To put this another way, if you can save another £2,000 per year, you've a very good chance of getting to your £200,000 target. Given that you have a passion for investing, think of such saving as a way of funding that passion.

This point generalises. What matters most for people with years ahead of them is not so much how they invest as how much they invest. As long as you avoid disasters - which you can by diversifying as well as you have - then a moderate level of savings should get you to your objective.

Alan Steel, the chairman of Alan Steel Asset Management, says:

I find it a bit concerning that you describe yourself as 'medium risk' but the present portfolio is closer to high risk - and very high in places.

I note you started investing 5 years ago, presumably about the time the stock markets were bottoming following the Lehman crisis. If you did you are exceptional. So perhaps you have the makings of a brave contrarian.

It is good that you like to learn from your mistakes. As part of this process, ask yourself whether your investments were acquired at the darkest hours during and since September 2008? Or were they purchased after strong recoveries? One danger for private investors like yourself is that they often buy when confidence returns, when prices have risen sharply. I note two of your last three trades are up sharply over the last year - was it the increase that attracted you, for instance?

I often compare giving financial advice to doing algebra at school, to the extent you start at one end and then come back from the other end to meet in the middle. Your starting point is now. You have 22 holdings, including 9 individual trusts and funds. By and large each holding is worth between £2,000 and £4,000, and it seems the total investment now is around £60,000. If you wish that to grow to £200,000 by 2030, and were to add no more fresh funds, you require a return after charges and tax of 7 per cent a year, which doesn’t seem excessive.

It makes sense to shelter your investments from tax in an individual savings account (Isa). And the annual allowances for Isa contributions are at a level that seems to fit what you can afford to contribute. But I do worry about the concentration on fairly speculative individual equities, together with the spread of trusts and funds at the higher end of the risk spectrum. It makes me wonder how you select these holdings.

I come back to foundations, and what I call the '80-20 Rule'. Research over the last 100 years or more shows that a portfolio set up with 80 per cent in large-cap value funds (with growing dividend payers) matched with 20 per cent in small-company value funds, provides by far the best returns.

I note your holding in the Diverse Income Trust (DIVI). Gervais Williams, the manager of this trust is a disciple of the above approach, and if I were you I’d build your portfolio on this well-worn 80-20 system. You have to understand that if you keep exposure to the higher risk end with the present mix, when market corrections come along - as they will often over the next 17 years, if the past is any guide - and a correction of at least 10 per cent is well overdue right now, then the fall in value of your holdings is likely to be much higher, and I wonder how you’ll react.

So I'd be recommending less individual special situations, less Emerging Market exposure and more in Value and Developed Markets. You ought not to ignore the findings that show consistently over time that Growth as a style falls way short of Value with reinvested dividends - in all world markets, forming the bulk of investor returns .

You should also check if you can inject leading funds into your private pension arrangements. This, I find, is often overlooked.

Finally a few words about your goals. You want to retire at 60, with an extra £200,000 outside your pension plans. Some perspective may assist. If a male today aged 43 wishes to retire at 60 with the equivalent of a gross £30,000 income, indexed at 3 per cent a year in retirement, and assuming 3 per cent inflation from now, current annuity rates would buy that income with a fund of almost £1.7m. And that assumes no bells and whistles or widow's benefits attached to the annuity.

So put everything in your Isa, keep saving and remember the foundations. Consider the 80-20 value-driven system. Don't be sucked in to higher prices in potentially volatile stocks, but rather increase exposure to trusts and funds with the best records. As to passive, if you are attracted to worse-than-average returns, that’s what you'll end up with.