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Reassess your risk appetite and get real on returns

Our reader needs to be more realistic about risk and the kind of annual returns he could make
February 2, 2017, Laith Khalaf & James Norrington

Lewis Dawson is 25 and has been investing for three years. He lives with his partner, and they both run their own businesses. They have no immediate plans to have children.

Reader Portfolio
Lewis Dawson 25
Description

Overseas shares and funds

Objectives

Growth of 10 per cent a year

Portfolio type
Investing for growth

"As a young investor, I am purely looking for capital growth," says Lewis. "I have no short- to medium-term need to access this money, and do not require an income from it. I am targeting a return of around 10 per cent a year.

"I have quite a high tolerance of risk, because as a director of a business I'm quite used to taking on significant investment risk, so it's something I'm quite used to living with. I could tolerate losing up to 10 per cent to 12.5 per cent of the value of my portfolio in a single year.

"Also, my investment capital came from an unexpected windfall so I haven't saved hard over many years to build this up. I suspect this makes me more inclined to take on risk than someone who has carefully grown it over the years.

"I favour momentum investing where I'm as confident as I can be in the business model of a specific investment. For example, I'm heavily weighted to US technology as I'm confident on this sector's growth potential - even with its high valuations. However, I'm aware that my portfolio needs some balance and it's likely that I'm overexposed to this sector.

"Recent trades include investing £2,000 into BlackRock Gold & General Fund (GB00B99BDY18) and £1,300 into BlackRock Emerging Markets Equity Tracker (GB00BJL5BW59), and selling an £850 holding in Quarto (QRT) after making an 8 per cent gain.

"I also have around £2,000 in easily accessible cash savings. I have been moving this cash around trying to find the best possible interest rates - no easy task - and intend to continue doing this."

 

Lewis's portfolio

 

HoldingValue (£)% of portfolio
Alphabet (US:GOOGL)2,46510.36
Amazon (US:AMZN)2,3309.79
BlackRock Emerging Markets Equity Tracker (GB00BJL5BW59)1,3005.46
BlackRock Gold & General (GB00B99BDY18)9,81841.25
CF Woodford Equity Income (GB00BLRZQC88)1,0564.44
Facebook (US:FB)2,3619.92
JPMorgan Emerging Markets (GB00B1YX4S73)1,5116.35
Jupiter India (GB00BD08NQ14)9063.81
Standard Life Investments Europe ex UK Smaller Companies (GB00BYMMJ932)530.22
Cash2,0008.4
Total23,800 

 

 

None of the commentary below should be regarded as advice. It is general information based on a snapshot of the reader's circumstances.

 

 

THE BIG PICTURE

Chris Dillow, Investors Chronicle's economist, says:

While your portfolio might - for now at least - be okay, I fear that your targeted return of 10 per cent a year might be too high. I would assume that the aggregate market will deliver a real return of only around 5 per cent a year. I'm not sure the momentum and defensive premia you'll earn on average will be sufficient to get you to 10 per cent. Lower your expectations.

I also fear you might be taking too much risk. You say this money came from an unexpected windfall which inclines you to take more risk. This fits a pattern: Richard Thaler has shown that people take more risk after unexpected gains. He calls this gambling with the house money.

But this is irrational. The odds are what they are, irrespective of how you got your money. While there's a case for running your winners in the near term, you might want to consider trimming your exposure to risk eventually. Be disciplined about following their 200-day moving averages, and be prepared to cut equity exposure when prices fall below them.

 

Laith Khalaf, senior analyst at Hargreaves Lansdown, says:

You have correctly identified that your young age gives you considerable scope to take on risk in search of long-term returns. However, you may need to upgrade how much you are willing to lose in a given year if you wish to maintain such a high octane approach.

As an investor in the stock market it's worth bracing for the worst-case scenario, which given historical returns would equate to a loss of 30 per cent to 40 per cent in an exceptionally stinky year, like we experienced during the financial crisis. However, with the rough comes the smooth, so despite these sorts of setbacks the FTSE All-Share index has returned around 9 per cent annually over the last 25 years.

Make sure your investments are protected from the taxman where possible, by holding them in self-invested personal pensions (Sipps) and or individual savings accounts (Isas).

 

James Norrington, specialist writer at Investors Chronicle, says:

Starting young is one of the biggest advantages you can give yourself as an investor, as it means you have more time to benefit from compound returns and recover from the inevitable short-term setbacks all investors suffer from time to time. Aged 25, however, and having only started investing three years ago, you did not experience the dramatic losses of equities during the 2008-09 financial crisis, so the first thing you need to assess is your true appetite for risk.

Peak-to-trough losses in a severe bear market like 2008-09 or 2000-03 can be much worse than the 10 per cent to 12.5 per cent loss you say would be tolerable. This also needs to be weighed up alongside the risks to your human capital in any accompanying recession - ie, loss of employment - which possibility is potentially high as you are a young entrepreneur. It is good that you have a £2,000 cash cushion but you should consider whether this would be enough alongside any other contingency arrangements in the worst-case scenario - if your business were to fail.

Your long-term focus on equities still makes for a high risk/reward strategy and should your circumstances change - for example, if you have a child or buy a house with a big mortgage - then you may need to reconsider your tolerance for risk, and whether the portfolio goals and investing strategy should be modified.

 

HOW TO IMPROVE THE PORTFOLIO

Chris Dillow says:

You say you have a high tolerance of risk, but I fear this portfolio might be even more risky than you think.

You say you could tolerate a loss of 10 per cent to 12.5 per cent. But your biggest holding - BlackRock Gold & General Fund - has an annualised standard deviation of almost 40 per cent over the last three years. This implies that there's a roughly 30 per cent chance of it losing more than 10 per cent over a 12-month period.

And if such losses occur, they are unlikely to be offset by your other holdings - in fact, quite the opposite. Mining stocks and emerging markets have for years tended to rise and fall together: both are global cyclicals. So if BlackRock Gold & General does badly, your emerging markets assets would probably do badly as well.

But this isn't necessarily a case for dumping the fund soon. Mining stocks have great momentum now, and we know that momentum pays off on average. One way to manage this is to watch out for the 200-day moving average: when the fund's price dips below this, consider selling, although momentum works in both directions.

In this context, consider what type of asset your US tech stocks, Amazon (US:AMZN), Alphabet (US:GOOGL) and Facebook (US:FB) are. The case for holding them - insofar as there is one - is that they are a different type of growth stock from what you might think. Their entrenched market positions give them forms of monopoly power - an ability to fend off potential competitors. They have what Warren Buffett calls "economic moats".

While growth potential in the conventional sense isn't worth paying for, because conventional growth stocks are often overpriced, moats are worth having as investors have in the past underpriced them. You should ask therefore: does the underrating of these stocks' moats offset the possible overrating of their growth potential?

Even if these stocks aren't defensive you do have one defensive asset: CF Woodford Equity Income (GB00BLRZQC88). It invests in big defensive stocks that have Buffett-style moats. With a bit of luck, the excess return that defensive stocks with good moats earn over time will more than outweigh the fees this fund charges.

 

Laith Khalaf says:

You have picked some really good funds to populate your portfolio, and the tilt to emerging markets is entirely sensible in your situation, as this is where a lot of tomorrow's growth is going to come from.

But as a whole the portfolio is not well enough diversified. Of particular concern is that almost half of it is invested in BlackRock Gold & General, which is a fairly specialist fund, and makes your portfolio too reliant on the prospects for gold and gold mining companies which are pretty cyclical. I would probably look to sell down around three-quarters of this holding and seek to reinvest in funds you already have or new opportunities.

As a young investor looking to take on risk you could consider recycling this money into UK mid caps and smaller companies. Doing this wouldn't necessarily reduce your risk, but rather spread it a bit more. Two funds for consideration in this space are Franklin UK Mid Cap (GB00BZ8FPJ50) and Marlborough UK Micro-Cap Growth (GB00B8F8YX59).

Around a third of your portfolio is invested in three US tech companies which is a lot of stock-specific risk to take on - even some of the punchiest fund managers would baulk at that concentration. I understand you have a high conviction in these stocks, but think you could taper down your position size in these. Certainly, as you build your portfolio I wouldn't add more to these stocks until they make up a smaller slice of the overall size.

 

James Norrington says:

I don't think there is anything wrong with your holdings in Facebook, Amazon and Alphabet. Even though these are mature businesses with their most spectacular growth phases probably behind them (Amazon being a possible exception), they have the brands, technological innovation and strategy to potentially deliver solid returns over the longer term.

Although your positions are large relative to your overall portfolio, you are young and have to start somewhere. I don't see the point in having very small holdings so, in absolute terms, allocations of £2,000 to £2,500 seem sensible. These may be tech companies but thanks to their phenomenal reach in terms of data they could provide a play on all sorts of other 21st century industries. But, going forward, you should think about other investments before you add further tech exposure.

Your use of collective investment schemes to diversify the portfolio is a good move. As you already have a great deal of exposure to the UK economy through your business ownership, it is perfectly reasonable for the majority of your investments to be international in nature.

An allocation of roughly 15 per cent to emerging markets is bold but not unreasonable over the longer term, given this is where most growth is expected to occur over your lifetime. Again, be aware that there will be bumps along the road for emerging markets and you will experience volatility in the short term - a rise in global protectionism and the strength of the US dollar are current headwinds. This is fine if you really can afford to just leave the investments grow over a long time horizon, but could become highly disconcerting if, for whatever reason, you need to liquidate positions during a down period.

The one holding I really dislike, from an asset allocation standpoint, is your gamble on precious metal mining stocks via BlackRock Gold & General Fund. This should only ever be a satellite holding but it makes up 41 per cent of your portfolio, which is too much. There are broader developed market plays that you don't have exposure to which would be better. I would consider selling the majority of your BlackRock Gold & General Trust units, and adding exposure to European and Japanese equities via index trackers - possibly cheap exchange traded funds (ETFs).

Also consider increasing your cash cushion to help ride out any tough times.