Holding penny stocks alongside blue-chip defensives

PORTFOLIO OF ANONYMOUS INVESTOR, AGED 37

Source: Investors Chronicle and *London Stock Exchange

**I Swiss franc = 0.66 pounds sterling

Chris Dillow, the Investors Chronicle's economist says:

You say you're learning to spread bet. I would warn you against this.

One problem is that short-term share price moves are almost wholly random and unpredictable, which means spread betting is just a form of gambling. And while gambling is good entertainment, it's no way to make a living.

In this context, technical analysis might even be worse than useless. It's very questionable whether it works on average, especially in developed, liquid markets. In fact, it might do more to increase your confidence than your knowledge, with the result that you simply trade too often. For this reason, Arvid Hoffman of Maastricht University and Hersh Shefrin of Santa Clara University have found that individual investors who use it have "dramatically lower returns" than others.

A second problem is that even if spread betting works in theory - which I doubt - it's harder to make it work in practice. If you don't set stop-loss limits you run the danger of endless margin calls. But if you set them too high you might be closed out of otherwise profitable positions if the price blips randomly downward. You also face the danger that, in volatile markets, the price might fall below your limit before your position is closed.

If you doubt my scepticism, just look at what the so-called experts do - or more precisely don't do. If spread betting were a decent way of making money, we'd expect to see fund managers sell their overpriced London homes, give up the grinding commutes and long hours, and buy nice country houses and live off the proceeds of spread betting. But very few (to say the least) do this. They don't do so because they know that their best hope for making money lies in using the resources of a big firm: having clever colleagues, access to companies and big data. What makes you think you can do better than them?

I'm also wary of your liking for penny stocks. It doesn't matter what price a share is, its downside is always 100 per cent. In fact, penny stocks are worse than others. One problem is that they tend to have large bid-offer spreads, which means they can be hard to sell. This wouldn't be so bad if you were rewarded for taking this risk. But you're not. Investors tend on average to pay too much for the small chance of big upside; there's plenty of evidence that lottery-type stocks are over-priced and so offer low returns.

If all this sounds harsh, there's one massive consolation. Your actual portfolio has got one big thing very right. It has a big weighting in defensive stocks such as utilities, Glaxo, Diageo and so on. The evidence from around the world tells us that defensives tend on average to out-perform; if penny stocks are over-priced, defensives are under-priced. Better still, defensives tend to be lightly correlated with speculative stocks, with the result that a mix of the two is a good way of spreading risk.

I like what you're doing a lot more than I like what you're saying.

I would warn you, though, that "defensive" is only a relative term. In bad times, defensives do badly simply because they are correlated with the general market; it's just that they usually do less badly than other stocks.

In fact, if anything you might be diversifying too well. A portfolio of 31 equities means that, to a very large extent, you are spreading idiosyncratic risk away; if a stock accounts for barely three per cent of your portfolio it won't make much difference to overall returns. The counterpart of reducing idiosyncratic risk is that you're taking on market risk - the danger of losing if the general market falls. Are you sure that your three bond holdings are sufficient protection against this?

This, though, isn't a grievous error. Quite the opposite. Taking on market risk is our best hope of decent long-run returns - almost certainly better than spread betting and penny stocks.

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

My first impression when looking at your portfolio is that you have done your research on portfolio construction. There is a sensible split between equities and bonds and your largest equity holdings are in solid, defensive, blue chip stocks. Most of these are utilities, which have performed relatively well in the latest market sell-off. Pharmaceutical giant GlaxoSmithKline (GSK) has had a tough time lately, however the solid cash flows and promising drugs pipeline means it is a solid hold for investors.

Your significant exposure to large cap defensive stocks and bonds would lead me to agree with your assessment that the portfolio is on the whole low to medium risk and generating a good dividend income. Given your age and the fact you have a relatively long investment horizon, I think you are a little cautious in your risk level and the way you have structured your portfolio. However, it is understandable that you take a lower risk stance when you are out of work. Should your employment circumstances change, I think it is reasonable for you to be a little more adventurous.

Outside of the blue-chip defensive stocks, there is an emphasis on oil and commodity stocks and the recent sell-off in these sectors is telling on the portfolio. We are not too concerned about the large-cap companies here. While the likes of Royal Dutch Shell (RDSB) and BP (BP.) have taken a knock, they have fared better than smaller companies in the sector and will muddle through the current low price environment. It may even be worth topping up your holding in Shell at the moment. However, the same could not be said for several of your small cap companies, especially those that are more exploration focused. You have done the right thing by allocating smaller holdings in these higher-risk stocks.

Given your lower-risk stance, I think your allocation to higher risk growth stocks is reasonable, although I would say they could be spread across other sectors. A notable sector that is missing is technology. It may be worth considering switching a couple of your high risk natural resources stocks into this sector.

Your portfolio also lacks exposure to consumer cyclical sectors, retailers or financials; however, I can understand your reluctance for doing so. We remain wary of the banks, and also the supermarkets while they are in intense competitive mode and will only serve to undercut each other. However, we believe the UK will continue along the path to recovery and, with a fall in oil prices, the consumer will be left with more disposable income. This should be good news for most other retailers.

With regards to you learning to spreadbet, my advice is to be very careful. If you don't manage your risk properly you could end up having margin calls. However, spreadbetting could complement your portfolio and strategy, allowing more short term trades at lower costs and opening up other investment opportunities that normally require larger initial capital outlays.

Finally, there isn't one form of analysis that is superior to the other. You say that if you had learned technical analysis before you bought Fresnillo then you would never have bought it. With technical analysis there are so many tools and methods that any purchase or sale can be justified by making a few minor adjustments to the assumptions. Technical analysis would not have told you that the Federal Reserve was going to begin tapering, and therefore we should hold off buying gold and silver stocks.

With fundamental analysis, you will never have all the information you want. A combination of the two, along with making an educated guess is your best route. You need to be right just over 50 per cent of the time with good risk management in order to be successful.