Is my recently established portfolio diverse enough?

Mike, age 45, is a self-employed communications consultant who earns about £25,000 a year. His wife earns about £52,000 a year and they have two teenage children. 

“Over the past few years I was increasingly frustrated by the returns on our cash individual savings accounts (Isas), so transferred them into stocks and shares during the first lockdown last year," says Mike. "I also consolidated the various workplace pensions my wife and I had collected into self-invested personal pensions (Sipps).

"So with a significant amount of money now invested, I wish to maximise our savings as much as possible over the next 20 to 30 years. At this stage, I do not have an annual retirement income target in mind – I just want to grow the portfolios as best I can. I also want to make sure that my family have a comfortable life as the kids grow up.

"Due to Covid and only having set up my business a year ago, we are saving just £250 a month into my Sipp. But my wife has a pension that should pay out £5,685 a year from age 60, and increase each year in line with retail price index inflation.

"For many years, I avoided investing as I didn’t understand it sufficiently and didn't want to risk our savings. I also wanted a large enough cash reserve for home improvements. I still have some cash savings as I am self-employed and building up my business, and we hope to do some building work on our home in the next two years.

"I have missed out on a lot of time in the market and this has probably cost me much more than I risked losing. So I don't want to waste any more time. I expect to keep the Isas invested for at least five years and the Sipps for longer. 

"I only invest in funds because, without expert knowledge, picking stocks directly would feel too much like gambling.

"Aside from some of the holdings in the Vanguard LifeStrategy funds, the only asset we have exposure to is equities. Are we over invested in equities, and should we consider other assets such as property and bonds? They feel much riskier at the moment but I am investing for the long term, especially in the Sipps, so where should I look in this regard?

"I have tried to diversify across different geographies by investing in passive tracker funds, but does this provide enough defensive protection? I don’t think I have built up a sufficient core of solid defensive funds around which I could hold more adventurous funds.

"Our holdings resemble a list of the current most popular buys chosen on the basis of past performance rather than future potential. We hold many Baillie Gifford funds, but should I reduce the allocation to them, especially given speculation on whether Tesla (US:TSLA) – a holding in these funds – can maintain its progress? Am I overinvested in certain funds and should I spread my money more widely?

"Also, we don't hold value funds because of their poor performance in recent years, so do we have too many funds that invest according to the same growth style? Since I started investing in June last year all of the funds' values have gone up. However, this year growth stocks have had some rough periods and I am keen to protect myself against any downturns."

NONE OF THE COMMENTARY BELOW SHOULD BE REGARDED AS ADVICE. IT IS GENERAL INFORMATION BASED ON A SNAPSHOT OF THESE INVESTORS' CIRCUMSTANCES.

Chris Dillow, Investors Chronicle's economist, says:

You face the dilemma confronting all investors looking for equity funds, that the best performers of recent months might now be holding overvalued stocks. The best funds to have held in the past 12 months are those that invested in stocks that thrived during the pandemic, such as Netflix (US:NFLX), Amazon (US:AMZN) or Tesla. But these are now on fancy valuations. And there’s no great reason to suppose that the stocks which did best during the pandemic will do best during the recovery.

We must be cautious about declaring shares to be overvalued simply because our knowledge is limited and the market sometimes knows more than us. And even if a stock is overvalued it can continue to rise a lot.

However, overvalued shares can fall a long way over a long time. The bursting of the tech bubble in 2000-03 showed that even stocks that survive the burst can lose 70 per cent or more. So investing in funds that have performed well recently is risky.

Ordinarily, I’d say that the solution is to hold tracker funds, and there is a strong case for doing this. You should think of them as funds of equity funds – the default option for investors who want equity exposure but are unsure of which market segments to favour. But there’s a risk with these. Just six stocks now account for over one-fifth of the S&P 500 index: Apple (US:AAPL), Microsoft (US:MSFT), Amazon, Alphabet (US:GOOGL), Facebook (US:FB) and Tesla. If these fall, they’ll drag down the S&P 500 and the global market generally.

To protect yourself from this, have decent holdings in non-US funds. There’s also a case for holding value stocks via equity income funds. High yields are often compensation for taking the risk that a stock will do badly in a recession, which is why value stocks did badly during the pandemic. But the counterpart to this is that they do well during upturns.

That said, this isn’t a case for piling into them. I fear some are already pricing in a lot of the coming economic upturn. But as you don't hold any value stocks, consider diversifying into them, perhaps as protection against the possibility that investors will rotate out of the tech stocks that have done well during the pandemic into recovery plays.

No amount of diversification among equities, however, can protect you from a generalised fall in the market. All this can do is mitigate your losses. To protect against a generalised fall in the market you need assets other than equities.

But this doesn’t mean that you should hold more bonds. These would protect against a fall in share prices, for example caused by fears about economic growth. But this insurance comes at a high price. Government bonds are on negative real yields so are guaranteed to lose money unless yields fall further. And they might rise if investors fear higher inflation or interest rates, meaning big losses.

I suspect that the safest protection against falling share prices is cash. Your loss on this is limited to the rate of inflation, so it has much less potential downside than bonds.

Adrian Lowcock, head of personal investing at Willis Owen, says:

As your objective is to grow your investments over a period of 20 to 30 years ahead of retirement, it makes sense to analyse both your Isas and Sipps as one, with the option of breaking them down separately for further analysis. Looking at them as one portfolio can really help to provide insight into its structure and how it might perform. 

Diversification, which is very important for managing risk and reducing the volatility in the value of a portfolio, needs to be considered in many respects. A portfolio should be diversified across stocks and regions, but also across investment styles and fund managers. 

Nearly half the of portfolio is invested via one asset manager – Baillie Gifford – which adds some risks. If something happened to that company a large part of your portfolio could be affected. Baillie Gifford also has a distinct growth style, which means that your portfolio is biased to long-term growth stocks. There is also some overlap between the funds' holdings, meaning that your overall portfolio's stock diversification is not as broad as you might expect. For example, Apple and Tesla each account for over 3 per cent of your Sipps and Isas.

The lack of diversification is compounded by Vanguard US 500 Stock Index (IE0002639775) and Legal & General Global Technology Index (GB00BJLP1W53), which have holdings in common with the Baillie Gifford funds. More than half of the Isas and Sipps are invested in the US.

Your portfolio has a significant large-cap bias, very little exposure to mid-caps and almost no exposure to smaller companies. Although these areas are risky, they offer some diversification as well as the opportunity for growth.

The only bond exposure is some of the holdings in the Vanguard LifeStrategy funds which, at less than 10 per cent of Isas' and Sipps' overall, is arguably low – even for an adventurous portfolio.  The bond exposure is also passive but, given where yields are, I would suggest more active exposure.

The exposure to tech and growth companies is understandable, as they have performed well in recent years and could easily drive performance in the longer term. But this exposure is also risky as valuations in parts of these areas are elevated. A well-diversified portfolio should deliver good performance in a variety of conditions.

It can be hard to build a portfolio, so it is good to plan how much you want invested in an area or style, and research how much each fund gives you exposure to the different areas.

I suggest reducing exposure to the Baillie Gifford funds, and Legal & General Global Technology Index and Vanguard US 500 Stock Index. Build a core portfolio around the Vanguard LifeStrategy funds, and make sure that you have no more than 10 per cent of the Sipps and Isas in any one fund.

Consider adding some different investment styles, and small and mid-cap funds. You could replace Baillie Gifford Managed (GB0006010168) with ASI Global Smaller Companies (GB00B777SP34). It would also make sense to add active bond exposure via M&G Global Macro Bond (GB00B78PGS53).

I also suggest adding some focused exposure to the UK and Japan, which are notably underweight in your portfolio. The UK is good for exposure to value, income and smaller companies funds. Man GLG Undervalued Assets (GB00BFH3NC99), Threadneedle UK Equity Income (GB00BDZYJT97) and Jupiter UK Smaller Companies (GB00B1XG9599) would help to provide exposure to these respective areas. 

For Japan equities, meanwhile, we like JPM Japan (GB00B235RG08).