Small Isa portfolio has "unusual construction"

MARY'S ISA PORTFOLIO

Source: Investors Chronicle. Prices and values as at 27 November 2013.

LAST THREE TRADES

Alent (buy), Costain (buy) and AstraZeneca (additional purchase).

WATCHLIST

TR Property, Monitise, Schroder Oriental

Chris Dillow, Investors Chronicle's economist, says:

This portfolio is smaller than many. Which poses the question: in what ways should the investor with a smaller portfolio behave differently from others?

First, you mustn't trade very often. This is because dealing costs will generally represent a larger fraction of a small portfolio than they do of a bigger one, and so your wealth will be more quickly eroded by costs if you trade a lot. Even more than others, therefore, you should be a 'buy and hold' investor.

In this context, I'm pleased you intend to "leave the portfolio alone". Do just that.

Second, you must resist the urge to get rich quick. You say you lost on two Aim oil stocks. I fear this wasn't merely because some risks materialised. It's because people tend to overpay for stocks that offer the small chance of huge returns. The upshot is that lottery-type shares - on average - tend to do badly. Although this is well-attested in the US, it's also true in the UK. Since its inception in 1996, Aim has fallen by 18 per cent while the All-Share index has almost doubled. This tells us that speculative stocks often disappoint. Sure, there are some '10-baggers' lurking among Aim stocks. But your chances of finding them are small. The wealthier investor might be able to afford to take this chance in a few speculative ventures. But the smaller investor should be more careful.

Again, you seem to have learned this lesson. This portfolio is slightly biased towards defensives, with Pennon, AstraZeneca and Dignity. History tells us that defensives have the opposite - and better - payoff structure than lottery stocks; a small chance of big gains, but decent long-run average returns.

Third, you must be especially careful to ensure you do not become a forced seller. One danger in holding an equity-heavy portfolio is that if you need to raise money for emergencies you might have to sell shares when their prices are low. For a smaller investor, such losses might be a large proportion of their total wealth. For this reason, please ensure that you keep enough cash to meet any out-of-the-ordinary expenses. Your emergency money should be your cash Isa, not your equity portfolio.

As for the general structure of this portfolio, I see no big problem. On average, over the long run it should stay ahead of inflation - although remember that even the best stocks will fall if the market falls. I would, though, warn you of two things.

First, it's possible that if we get a vigorous economic upturn then your corporate bond fund might suffer. This is simply because in such conditions investors would shift out of safer corporate and government bonds and into riskier assets. However, I don't regard this as a reason not to hold such funds. In bad times, bond funds protect you (to some extent) from falls in share prices. The price you pay for this is underperformance in better times.

Second, I don't like your preference for dividends "because they relieve me of the responsibility of crystallising growth profits". I say so for two reasons.

First, the case for dividend stocks is not that they make life easier. Instead, the case for them lies in one of two alternatives. One is that, in some cases, a high yield is a sign of an especially cyclical stock - and cyclical risk could pay off if the economy continues to recover. Alternatively, some high yielders (such as utilities and tobacco) are defensives, and such stocks tend to do well over the long term on average. If you're buying a yield stock for any other reason, you might well be mistaken.

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

This portfolio should meet your objectives, including keeping ahead of inflation and being liquid. While the yield of the portfolio is not bad at all, bear in mind that given the limited size of the portfolio, any cash generated can only be negligible. Over the longer term, though, as the portfolio grows so will the income that you could potentially draw upon.

However, this portfolio does have a slightly unusual construction. While your overall asset allocation is sound, I have some reservations about the direct equity holdings. For an investor who is fairly conservative with regard to risk, it seems as if there are relatively few lower-risk big blue-chip shares in the portfolio, just AstraZeneca and Pennon.

While AstraZeneca provides a very good income, with a prospective of 5.3 per cent, uncertainties remain on whether it can deliver through research and development and acquisitions to stem revenue declines due to patent expirations. Pennon's waste business continues to cause a headache for the group and we prefer other stocks in the sector, such as United Utilities, which provides a superior dividend yield and is operationally more sound.

The companies you hold would normally be classified as medium- to higher-risk investments, which provide good growth opportunities but with less of a dividend return. Overall, these don't match your conservative attitude and the portfolio has a much higher risk to a cash alternative you have indicated you are seeking.

There is a slant towards infrastructure, engineering and industrials within the portfolio, from both your holding in the 3i fund and stocks such as Costain, Shanks, Carr's Milling, Alent and Pennon. As investment in infrastructure is one of the routes towards boosting the economy, these are areas which to a certain extent are expected to do well. However, a heavy weighting in this segment is at the cost of diversity and opportunities elsewhere. While you have exposure to utilities and pharmaceuticals, some of the traditional lower-risk, high-yielding sectors, you may wish to consider the two big oil companies, BP (BP.) and Royal Dutch Shell (RDSA), and some exposure in retail or consumer-facing businesses.

Your individual bond holdings provide an attractive income and your exposure to bonds is 24 per cent. Although this is a little on the low side, it is okay for now providing you focus towards transitioning your portfolio to be more bond heavy over time. To increase the bond exposure, I would prefer to opt for a fund due to the diversification benefits and to enable you to take a step back from the management of the portfolio.

For small portfolios and small investment sizes you must consider commissions and other costs. Most brokers charge around 1 per cent with a minimum commission size. Your recent investment in Alent is valued at £207 and if we assume that the minimum commission charge was £10, you would have effectively paid a commission level of around 5 per cent on this trade. This is effectively the same as wiping out a year's worth of dividends from most stocks, or the share price would have to rise 5 per cent before you're in profit - not taking into consideration the spread.

I would recommend letting your cash position to build up to slightly larger amounts before investing. Additionally, you could look at a regular investment plan where commission charges can be more attractive and make investing in small sums more cost effective. It also enables you to benefit from pound cost averaging, where you purchase less shares when the share price is high and more in the dips. It may also be helpful to discuss your portfolio with your broker when making changes, if only for no other reason than to get a second opinion on your thoughts and the suitability of the inclusion of the investment in your portfolio.