Can I continue to generate 10 per cent a year?

Mervyn is age 58 and earns £41,000 a year. His children are in their 20s and becoming financially independent. Mervyn and his wife’s home is worth around £220,000 and they will have repaid the mortgage on it by 2023.

"I want to partially retire at 62, reducing my work to three or four days a week," says Mervyn. "From this point, I will supplement my income by drawing two former workplace defined benefit pensions (DB). These will pay income of £8,696 and £3,096 a year, and lump sums of £26,532 and £9,288, respectively. I am also due to receive a third former workplace DB pension which will pay income of £1,654 a year and a lump sum of £1,692.

"I have been investing for 13 years and intend to keep on doing this as much as I can. I outsourced the management of my investments to a wealth manager for about 10 years and it delivered a total return of about 10 per cent a year, on average. But the wealth manager also charged 5 per cent a year for its services and I wanted more control over my investments so I decided to take a more hands-on approach.

"I have set up a portfolio of five funds, which I hold in a self-invested personal pension (Sipp) and two direct shareholdings which I hold in an individual saving account (Isa), alongside cash. I want to grow my capital by investing in a small number of growth funds, and have chosen ones that mainly provide exposure to equities listed in China and the US.

"Recent portfolio additions include adding to Howden Joinery (HWDN), Bloomsbury Publishing (BMY) and Baillie Gifford China (GB00B39RMM81).

"I would like to continue to generate a total return of 10 per cent a year, on average, 5 per cent of which is income. However, since I took responsibility for my investments in October 2020 their returns have taken quite a hit. But I don’t want their value to fall more than 5 to 10 per cent in any given year."

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:

Only holding a few funds and shares is not necessarily a problem as you can have a well-diversified equity portfolio with just one fund – a global index tracker. However, you are heavily exposed to China via Baillie Gifford China and Fidelity Asia Pacific Opportunities (GB00BQ1SWL90). You also appear to be heavily exposed to US big tech stocks: Baillie Gifford Long Term Global Growth (GB00BD5Z0Z54) had 35 per cent and S&W Aubrey Global Conviction (GB00BJ34P394) had 25 per cent of its assets in tech stocks at the end of March. Both of these have done badly in recent months, hence your portfolio's poor performance.

I suspect this reflects a widespread mistake that investors make. Many believe that long-term growth in demand and output equates to good equity returns. But this is not true. There has been very little correlation in many countries between longer-term economic growth and equity returns for years. For example, over the past 10 years Chinese equities have risen only 0.7 per cent a year in US dollar terms, while eurozone stocks have risen 3.3 per cent – even though China’s economy has grown much faster.

One reason for this disparity is that the benefits of economic growth do not necessarily accrue to listed companies. They can instead flow to foreign or unlisted ones, or to companies which have not yet started trading. Or economic growth can benefit governments and sometimes even workers.

Another reason why equity returns do not necessarily reflect economic growth is because expected growth is in their prices – you get what you pay for. This entails a risk, as stocks such as Netflix (US:NFLX) and Peloton Interactive (US:PTON) have recently demonstrated. Corporate growth is largely unpredictable and this, combined with high valuations, this can lead to big share price falls if expected growth is revised down.

We cannot say whether valuations of US stocks have now fallen sufficiently to become attractive. One lesson of bear markets is that prices can overshoot on the downside, hence the saying 'never try to catch a falling knife'.

But you might wish to diversify a little better. This doesn’t require much thought as global tracker funds are one way to do this. These are also cheaper than active funds – a helpful attribute, as even slightly higher annual management charges compound horribly over time.

I'd also question holding Baillie Gifford Managed (GB0006010168), which invests in both equities and bonds, because you might not not need exposure to bonds. These are a good hedge against some types of equity risks, such as those caused by heightened risk aversion or fears of recession. But, as we’ve seen recently, bonds do not protect investment portfolios when equities fall because of fears of rising interest rates. Cash is better protection against that. Although its value gets eroded by inflation, as does that of bonds, it’s not impossible that real interest rates will turn positive in the next couple of years which would make cash more attractive.

And if you still want to hold bonds you can do this more cheaply by investing in dedicated bond funds or exchange traded funds (ETFs). I don't think that managed funds do anything that self-managed portfolios of equities, bonds, cash and gold can't.

Christophe Beaupain, financial consultant at Timothy James & Partners, says:

You have been investing for the past 13 years, but this is after the financial crisis of 2008-2009 – a period which has mostly been very good for investment returns. But since you started managing your own investments in October 2020, markets have been far more volatile.

A 10 per cent annual total return is ambitious and you may need to take a higher level of investment risk to give your investments greater opportunities to deliver such returns. But maybe reconsider this objective as it is is not in line with your tolerance for loss of only 5 per cent to 10 per cent a year. 

If your three former workplace DB pensions start at the same time as you reduce your work, they should be sufficient to maintain your level of income if you work four days a week. However, if you only work three days a week from age 62 there might be a slight shortfall between then and when your state pension starts at age 67. If your income is more than sufficient to support your lifestyle until then and you will receive the full state pension, which is currently £9,628 a year, you will need to finance a shortfall of around £17,926 a year. You will have repaid your mortgage by then which is likely to reduce the shortfall.

It helps that you are able to build up your investments further. Your final salary pensions lump sums could also be added to your Isa over a couple of tax years.

About 40 per cent of your Sipp is in cash and, although since November 2021 this was probably the second-best performing holding in it, it would be prudent to increase diversification. 

Three of the five funds in the Sipp are managed by Baillie Gifford which takes a growth investment approach. However, over the past six months this investment style has faced a number of challenges which have particularly affected performance when value style investing has outperformed growth. For example, between November 2020 and November 2021, Baillie Gifford Long Term Global Growth was up 26.41 per cent. But between November 2021 and May 2022 the fund fell 42.06 per cent.

If you have an ambitious target of a 10 per cent total return, you need to hold equity funds. But with large exposure to Asia and China, and Baillie Gifford Long Term Global Growth, consider whether quite that much volatility is appropriate in the years leading up to your retirement. Care and thought also needs to be applied when selecting certain funds to ensure that your portfolio is diversified by geography and style.

Considering the amount of risk for the reward you are getting, I would add the cost-effective Fidelity Index World (GB00BJS8SJ34) and BlackRock Global Unconstrained Equity (GB00BFK3ML85) funds. These will help to diversify your Sipp away from a high growth exposure and blend different styles. And taking the same timeframes over which we looked at Baillie Gifford Long Term Global Growth, BlackRock Global Unconstrained Equity was up 36.03 per cent  between November 2020 and November 2021 and down 16.49 per cent between November 2021 and May 2022.

Also consider Trojan Global Income (GB00BD82KP33) as its yield could be reinvested to benefit from compounded capital growth.

Vanguard LifeStrategy 60% Equity (GB00B3TYHH97), meanwhile, is a very cost-effective multi-asset fund that has broadly the same level of risk as Baillie Gifford Managed but is less reliant on growth style investing.

Global funds typically have larger allocations to the US, UK and Europe, so also having funds focused on Asia is helpful. Fidelity Asia Pacific Opportunities (GB00BQ1SWL90) is good but maybe complement it with the more value oriented Schroder Asian Income (GB00BDD29732) which has a yield of around 3.7 per cent.

Direct shareholdings, as you have in your Isa, are very high risk. Following columnists to get ideas on what to invest in can be interesting but you have the risk of market timing and need to decide how long you will hold the share for. Market commentators rarely provide helpful suggestions on when to exit the positions – something which is difficult to judge. If you invest in active funds, their managers decide what to hold, and when went to enter and exit them on the basis of a lot of analysis.