Are my allocations right for my time horizon?

Oliver is age 37 and earns £70,000 a year. His partner also works, but does not have any investments. Their home is worth about £700,000 and has a mortgage of £250,000.

“I am building my wealth and not taking income from my investments,” says Oliver. “I have a long-term investment time horizon of 10 or more years and would like to make an average annual total return of more than 5 per cent.

“My salary covers my current expenditure, and is likely to grow enough to cover possible increases in our expenditure as we plan to have children in the next five to 10 years. But I may need to draw from the investments in about 15 years to support costs such as education. I may also need to draw from the investments in 20 or more years for retirement income. I hope to retire by age 60, although am flexible and would be open to reducing the hours I work around that age rather than fully retire.

"I have a defined-contribution workplace pension worth about £25,000. I make contributions on a salary-sacrifice basis and my employer contributes 5 per cent. I have also set aside some money which is run by a financial planner to fund additional pension contributions over the next few years. This is worth about £125,000, and held in cash and a general investment account, 80 per cent of which is in global equities and 20 per cent in passive bond funds. It is being drip-fed into my pension to maximise annual contributions.

"I have a reasonably high risk tolerance as I do not rely on the investments for income and hold about 10 per cent of my entire assets (including my home) in cash. I could tolerate my investments’ value falling by up to 30 per cent in any given year in times of high volatility. However, I want to ensure that I’m making sensible decisions with an appropriate level of risk and reward for my investment time horizon. I am unsure what the right allocation to cash is – especially in the current low-interest-rate environment.

"I started investing relatively small amounts into direct shareholdings five years ago, and then started to put money into active funds to reduce risk as the value of my investments increased. Inheriting cash made me think more about my asset allocation.

"I take a buy-and-hold strategy with my investments, although have a 20 per cent stop-loss [order placed with a broker to buy or sell a stock when it reaches a certain price] on the direct shareholdings. I aim to have no more than 30 of these, so I recently sold RSA Insurance (RSA) and Kerry (KYGA), and reinvested the proceeds in HarbourVest Global Private Equity (HVPE) to rebalance the portfolio. I plan to reinvest the proceeds from further sales of direct shareholdings in investment trusts and alternative assets. But I would like to make some speculative investments over the long term in direct shareholdings such as Harvest Health & Recreation (US:HRVSF) or Slack Technologies (US:WORK).

"I am also thinking of selling some of my holdings in active funds.

"I choose direct shareholdings using growth and value screens, and consider the industry they are in, the companies’ strategic goals and press reports. I choose funds according to what I read about them in the press, past performance and their managers."

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

TAX PLANNING

Keir Ashman, pensions and investments specialist at Bancroft Wealth, says:

You have a good understanding of your financial objectives and how to invest to meet these. However, it can be easy to overlook tax rules.

Although you are only 37, you would benefit from establishing a retirement income goal and undertaking a cash flow modeling exercise to see if you are on track to meet this. For example, you might find that you need to contribute more to your pensions in future. 

As a financially secure higher-rate taxpayer, consider prioritising funding your pension over your other accounts. Also consider using your general investment account and individual savings account (Isa) to fund pensions in the future, as pensions are by far the most generous tax wrapper for you.

Another possible option is venture capital trusts (VCTs), although these are only suitable for investors with a high risk tolerance and considerable investment experience. VCTs allow you to reduce or eliminate your income tax bill each year, receive tax-free dividends throughout the period of investment and exit after five years with no tax consequences. VCTs can also generate strong returns which, importantly, are not strongly correlated to wider stock markets, helping with portfolio diversification.

HOW TO IMPROVE THE PORTFOLIO

Keir Ashman says:

It would be a good idea to do a risk profiling exercise with regard to your non-pension accounts. This would help you to determine a suitable asset allocation for these, for example the split between the main asset classes such as equities, bonds, property and cash. Then on a more granular level it could help you to determine an appropriate split between different geographies, sectors and investment styles such as growth and value.

Asset allocation has been shown to provide the greatest contribution to returns over the long term, while individual fund and stock selections have proved to be relatively small contributors. 

Your plan to reduce the number of direct shareholdings and reinvest the proceeds in funds such as investment trusts is sensible. Unless you have the time, inclination and resources to conduct individual stock analysis, this is best outsourced to professional investors.

Another benefit of selling direct shareholdings would be the opportunity to crystallise losses on poor performers against the gains on strong performers, meaning you may not incur capital gains tax (CGT) on sales outside your Isa.

Your general investment account and Isa are heavily skewed to growth sectors, which over time are likely to make high returns. However, the divergence between growth and value sectors has never been greater, so your portfolio could be exposed to unnecessary market risk. Although this is not a directly comparable period, the Nasdaq index fell 90 per cent during the dotcom bubble in the early years of this millennium, and has taken 20 years to recover. Adding some UK equity income funds could be a good way to start addressing this.

Chris Dillow, Investors Chronicle's economist, says:

This portfolio is overdiversified, which means that you are wasting time. On average, each holding [excluding your home, pensions and cash] only accounts for 1.6 per cent of your investments. This means that even if one outperforms by 50 percentage points over a year, which would be a fantastic achievement, it would add only 0.8 percentage points to your annual overall return. But this is less than the difference between a single good day and a bad day for your investments.

And a portfolio with so many assets is likely to perform like a tracker fund because for each outperformer there is likely to be an underperformer. This is no bad thing, except that you are paying active fund fees. So you have a tracker fund but at excessive cost. And for a long-term investor, these costs add up horribly. For example, over 20 years, an extra half percentage point of fees could easily cost you over £20,000 for every £100,000 you invest.

So simplify your investments by cutting losers, enabling you to avoid adverse momentum effects. Also consider whether cheaper active funds might do a better job than your existing active funds and direct shareholdings.

Cutting holdings is difficult due to the fear of missing out. You might kick yourself if you sell something which then does especially well. One way to overcome this problem is to think of portfolio construction from the top down rather than bottom up. 

Hundreds of stocks and funds look good, and around half will beat the market over the next few months. But you should not own that many. Instead, consider how you should split your money between equities and safer assets such as cash and bonds.

It’s reasonable for you to have a big equity weighting because you don’t need income and can reinvest dividends. This matters a lot as, over the long term, it’s likely that around three-quarters of equity returns will come from reinvested dividends rather than capital gains.

Then consider what sort of equities you want. The default here should be a global equities tracker, to which you could add emerging markets and private equity funds to spread the risk that developed markets-quoted companies won’t grow much. You could also add defensive stocks, which are held by certain funds, as these outperform over the long run. If you want to be an active stockpicker factor in momentum as well.

But you cannot be a long-term passive holder of direct shareholdings. Hendrik Bessembinder at Arizona State University has pointed out that most shares underperform the market and cash over their lifetimes. This is because many fall victim to creative destruction. The market’s long-term returns have been driven by a handful of great performers. If you miss these, you’ll underperform over the long term.

So either adopt a much more passive strategy or, if you are active, be ruthless in cutting losers. Your stop-loss rule is sensible, so remember to apply it.