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Assessing the risks worth taking

Our reader wants to achieve better returns even if that means higher risk

Mr Vince is 58 and started investing two-and-a-half years ago when an endowment matured in mid 2013. He had already paid off his mortgage and didn't need the money, but felt he should put it to work. After considering his options he decided to invest in the market.

Reader Portfolio
Mr Vince 58
Description

Sipp, Isa & trading account

Objectives

Growth to maximise options in retirement

"I would like to grow my portfolio, partly because I enjoy the challenge of investing but also to maximise my options in retirement," says Mr Vince. "I would like to achieve a better return than savings accounts or bonds, and ideally outperform the FTSE 100.

"I live with my partner and if anything untoward happens to me she will be well provided for from my pension. I have no dependants, so I am able to take a high-risk approach to investing. I've recently discovered that market falls don't worry me, as I am fortunate enough to not be reliant on my portfolio.

"I am in full-time employment and plan to retire in two years at age 60. By this time I forecast that my final-salary pension plus self-invested personal pension (Sipp) will be worth around £1m, assuming 5 per cent annual growth in my £129,000 Sipp. I have stopped investing in the Sipp to avoid exceeding the lifetime allowance. I use my full annual individual savings account (Isa) allowance, and I expect to continue investing from my final-salary pension well into retirement.

"I participate in my employers' share scheme, and every so often I withdraw the tax-exempt amount and reinvest it in other shares.

"I invest £2,500 a month on average, but don't invest in funds because I prefer to make my own decisions. I also don't think it's fair for fund managers to charge their full percentage irrespective of performance. I realise this aversion to funds is probably heresy, and I may be classed as barking mad by anyone who assesses this portfolio. I don't hold any bonds because they offer a poor return at present.

"I am inspired by Warren Buffett and my preferred approach is to buy shares in companies that: offer a dividend of over 3.5 per cent with at least 1.5 times cover, have positive and growing earnings over the past five years, and don't have too much debt.

"I also need to understand a company's business model to a reasonable extent. Interserve (IRV) is a good example of what I like, but I cannot always find companies that meet all my requirements. So recently I have included companies with growth rather than value characteristics such as Unite (UTG) and Pets at Home (PETS).

"I diversify by buying into different sectors, and achieve some foreign exposure via companies that trade abroad such as Unilever (ULVR) and HSBC (HSBA). By getting foreign exposure this way I avoid poorly governed foreign companies.

"I have bought into property via Hansteen (HSTN) and Unite. I chose them on their individual merits, but also because they operate in different property markets, which I think helps with diversification.

"With somewhat less conviction I have invested in European and emerging market trackers for further diversification. I don't hold more than one company in each sector so, for example, if I buy Lloyds (LLOY) I will sell HSBC.

"I think I now have enough holdings and I plan a major review of the portfolio every three years or so, at which point nothing is sacred.

"I avoid anything I don't understand, for example structured products and anything that uses leverage - especially hedge funds.

"My last three trades were purchases of Shell (RDSB), Rio Tinto (RIO) and Pets at Home.

"I don't have any companies on a watchlist, but I would like to find a suitable investment in the pharmaceutical sector, and I may put another £6,000 into a generalist venture capital trust (VCT) in the next tax year."

 

Mr Vince's portfolio

HoldingNumber of shares/units Value (£)% of portfolio
BAE Systems (BA.)5,63329,06610.57
BlackRock Continental European Equity Tracker (GB00B83MH186)10,0499,9663.62
Essentra (ESNT)1,89813,9315.06
Galliford Try (GFRD)95514,1815.15
Hansteen (HSTN)15,25216,9606.17
HSBC (HSBA)3,56217,5356.37
Interserve (IRV)4,13319,2767.01
Marston's (MARS)10,43616,4575.98
National Grid (NG.)1,54915,2705.55
Pets at Home (PETS)6,92817,8046.47
Rio Tinto (RIO)4607,8842.87
Royal Dutch Shell (RDSB)1,00015,2105.53
Standard Life (SL.)2,95710,7513.91
Unilever (ULVR)60218,5716.75
Unite (UTG)2,34915,1045.49
Vanguard FTSE Emerging Markets UCITS ETF (VFEM)2624,7231.72
William Hill (WMH)2,71710,5693.84
Albion Venture Capital Trust (AAVC)na53421.94
Cash Isa165006
Total275,100

 

THE BIG PICTURE

Chris Dillow, Investors Chronicle's economist, says:

You are not barking mad at all to avoid high-charging funds. Quite the opposite. As David Blake at Cass Business School among others has shown, most of them underperform the market.

You're also right to avoid structured products. These might have a place in the portfolios of investors who are more than on average vulnerable to the small risk of a very big fall in the market. But you are not one of these.

However, your actions belie your claim to be inspired by Warren Buffett. Yes, his success is due to his preference for quality defensive stocks: cash-generators with good growth. In fact, economists at AQR Capital Management have shown that almost all of his good returns are due to his strategy - quality defensives - rather than to good stockpicking within those types of shares.

However, you're doing something he doesn't. If he can't find good stocks, he doesn't invest. But you have strayed into growth stocks. This is not like Warren Buffett at all. He wants companies to have 'moats' - things that protect them from competitors. Some of your holdings fit this bill: Unilever has strong brands and National Grid (NG.) has big capital requirements, both of which exclude competitors. But I'm not at all sure that a chain of pet shops has any such moat.

I fear, therefore, that you lack one of Mr Buffett's rare qualities - discipline. Perhaps you should remember the advice of American theatre producer Martin Gabel to a wildly gesticulating actress: "Don't just do something; stand there."

 

Nigel Hibbert, investment manager at Quilter Cheviot Investment Management, says:

What is striking is how considered your strategy is: clarity of thought, conviction, and your focus on dividends and their sustainability. Although you are deploying a relatively high-risk strategy this is not in conflict with your circumstances.

But if you were a client of mine, while not discouraging your ethos to invest in any way, I would want you to appreciate what a strong financial base you have, and that at some point it will be time to stop accumulating and start spending.

Your current investments are a good base for a portfolio, but the level of concentration in equities and the individual holdings themselves is a little higher than we would feel comfortable with, so we would diversify it to lower the absolute risk. While portfolios can easily be diversified beyond meaningful effect, there are also key attributes and benefits to diversifying - and never more so than in the unsettled and turbulent conditions that have been prevalent of late, and frankly have become the norm.

Just as you wouldn't set off for a round of golf without a full set of clubs, it is important to be open to new ideas and not be too narrowly focused: take all your clubs with you - even if you don't think you will use some of them.

 

Mark Richmond-Watson, portfolio manager at James Hambro & Partners, says:

Many do-it-yourself (DIY) investors buy too little of too much too often - dragging down performance with fees. You have avoided this trap and demonstrated some good stock selection with holdings such as Royal Dutch Shell, Unilever and National Grid.

You can clearly afford to take risk, and you are certainly doing that with such a concentrated portfolio.

I suspect some of the stocks have done well, like Unilever, which is up nearly 30 per cent over two years and represents 7 per cent of the portfolio. But you could benefit from some rebalancing: consider banking some of your gains to fund new holdings in other sectors. You have three property holdings, but no media or telecoms, for example. Companies such as AstraZeneca (AZN) in the UK or Novartis (NOVN:VTX) in Europe could meet your aim of adding a pharma stock to the mix.

 

HOW TO IMPROVE THE PORTFOLIO

Chris Dillow says:

I'm confused: you say that you want a high-risk approach and that market falls don't worry you. Why, then, try to diversify at all? Diversification, by definition, dilutes returns: it means less upside as well as less downside. Warren Buffett has said that: "Diversification is protection against ignorance. It makes little sense if you know what you are doing."

And you are very imperfectly diversified. It is difficult to spread risk by investing in equities alone simply because almost all shares are exposed to market risk and so would fall to some degree when the general market falls. For example, BAE Systems, your biggest holding, is quite highly correlated with Interserve and HSBC - all did badly over 2008-09 and well in 2013, as the general market fell and then rose.

The only way to avoid market risk is to hold non-equity assets such as cash or bonds. Yes, expected returns on bonds are poor. But so too are expected returns on any insurance product.

If you must diversify your equity exposure, ask yourself what risk factors is each stock exposed to? And if you are unwilling to take on such exposure, how can you mitigate it?

For example, Rio Tinto carries not just market risk but cyclical risk and, as you've discovered, it will do badly if investors worry about a global downturn. This risk might be worth taking: Rio might continue to recover if the world economy shows signs of perking up. If you want to get some protection against it, look for less cyclical stocks. You have done this, with stocks such as Unilever and National Grid (NG.). And you're probably right to do so, simply because history and theory tell us that defensive stocks do well on average over the long run.

 

Nigel Hibbert says:

Don't always limit yourself to one stock in any particular area. Life insurance is an example of a sector where we like to accommodate three plays for three distinct attributes: Prudential (PRU) for Asian growth, Legal & General (LGEN) for consistent cash flow growth and Aviva (AV.) as a restructuring play through Friends Life.

A higher-risk portfolio doesn't have to be at full tilt all of the time, and there are fundamentally attractive opportunities across a host of asset classes. For example, convertible bonds within fixed interest, or within real estate Henderson UK Property (GB00BP46GG64) or Secure Income REIT (SIR) as actively managed plays.

One of our convictions is to add value for our clients and identify active plays over passives where it makes sense to be in a collective fund, for example specialist areas. Funds are also generally a better way to access overseas equities. Where we can access institutional rates for clients costs are materially different to even just a few years ago.

 

Mark Richmond-Watson says:

My big concern is that your aversion to funds may be stopping you thinking more globally. Currently there is no US exposure, and the only exposure to overseas shares - and low exposure at that - is through an emerging markets ETF and BlackRock Continental European Equity Tracker (GB00B83MH186).

BlackRock Continental European Income Fund (GB00B3Y7MQ71) has outperformed BlackRock Continental European Tracker by 15.6 per cent in the past three years. It has an ongoing charge of 0.93 per cent compared with 0.1 per cent for the tracker, however the performance is net of fees. There's no guarantee that you'll get what you pay for with an active manager, but choose well and you should benefit.

That said, one area where you could do well from passive management is the US. Active managers have typically struggled to outperform the index. A tracker such as the Vanguard S&P 500 UCITS ETF US$ (VUSD) could provide useful US exposure to the portfolio, adding both diversification and US dollar currency exposure.

You are in favour of investing in a VCT, which seems to contradict your aversion to funds. Is this a case of the tax tail wagging the dog? It would give you exposure to small-cap companies, but it is also higher risk: VCTs tend to have concentrated portfolios and often have higher costs, including an initial charge.

If you have a desire to invest in small-caps there are a number of cost-effective funds with experienced managers and long, successful track records, such as CF Miton UK Smaller Companies (GB00B8JWZP29), which has generated a return of about 66 per cent over three years.

Introducing a US tracker and overcoming your aversion to fund management in markets where expertise is worth the costs could give you more chance of outperforming the FTSE 100 and add some diversification, allowing you to concentrate on your core FTSE 250 best ideas portfolio.