How can I build up a deposit for a first home?

William is age 18 and has recently started a job in financial services on a salary of £21,000 a year before tax. He lives with his family to whom he pays some rent.

“I contribute about 4.75 per cent of my salary to my work-place pension and my employer puts in 3.5 per cent,” says William. “But I would also like to allocate a proportion of my salary every month to another investment portfolio to build up a sum of £30,000 to £40,000 as a deposit for a property worth about £250,000. I would like to do this over the next five years.

"I will initially invest £5,000 from my savings, and then add £500 to £750 a month. I plan to hold the investments within an individual savings account (Isa), and I would like them to make an average annual return of 4 to 6 per cent after fees, over five years.

"I would then like to continue investing via a similar long-term strategy to amass a larger portfolio. This would be to eventually generate an income from property or another means that would cover my living expenses.

“I have a relatively high risk tolerance, as with current market uncertainty it is necessary to tolerate the possibility of losing money. Also, no one depends on me financially, I am young and I have the ability to earn back losses over time. So I would be prepared to lose up to 8 per cent of the value of my investments in any given year.

"That said, I hope to adopt a more conservative approach and make sustainable gains over a long period of time. So, to dampen equity volatility, I intend to invest 30 per cent of my self-managed investments in bonds. I also plan to hold 10 per cent of this portfolio in a cash Isa or NS&I Premium Bonds. I need an element of liquidity that is quickly available so that I do not have to make any forced sales of investments.

"I would like to take a long-term value-style approach with my investments, looking for under-appreciated opportunities. I aim to hold the funds I invest in for at least three years. I also don’t want too many holdings to begin with and to over-diversify, because I could do this by just investing in a broad equity index tracking fund.

"I have been creating hypothetical portfolios for over a year. Between September 2019 and February 2020, I created a small portfolio via an app, and logged the securities I allocated to, their performance and my thoughts about them in an excel form. In late March, I attempted to capitalise on market volatility by adding companies I thought would fare well and catch the commodity rebound. This resulted in a 20 per cent ‘net profit.’"

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

Sarah Coles, personal finance analyst at Hargreaves Lansdown, says:

As a general rule, five years is a short time horizon for investment. Usually we would say that if you definitely need the money at a specific point in time within five years, you should stick to cash savings.

However, in your case there may be some flexibility. You could move the purchase date if you hit your targets earlier or later than expected. Or you could buy a less expensive property or put down a smaller deposit.

If you have enough flexibility and understand the risks, you could put a portion of your money into investments. Consider a split along the lines of 50 per cent cash/50 per cent investments for your five-year goal.

It’s worth holding the chunk of the money you plan to use as a deposit for your first property within a Lifetime Isa. You can contribute £4,000 a year to this, and the government will bump it up to £5,000. Investment growth within Lifetime Isas is free of tax – just as with stocks and shares Isas.

This would use up £4,000 of your overall £20,000 annual Isa allowance. So at your rate of annual saving, you will be able to put all of the rest into a stocks and shares Isa.

After you have bought a property you may be able to take a longer-term view, and rebalance your portfolio away from cash and allocate more heavily to investments, to maximise potential growth. But, even then, don’t neglect cash: investing over the long term can be incredibly rewarding, but you also need an emergency savings safety net worth around three to six months’ essential expenses in cash. This will give you something to fall back on if life throws you any surprises.

Chris Dillow, Investors Chronicle's economist, says:

It’s fantastic that you are going to start investing young. You will make many mistakes over the time that you invest, but when you learn from your errors you should still have many years in which to benefit from that learning.

Some of the more common investing errors include being overconfident about your ability to predict corporate growth, over-estimating the pay-offs of speculative shares which, on average, do less well than expected, cutting winners too soon, running losing stocks in the hope of getting even, and trading too much. But you seem alert to the risk of making some of these errors.

You can reinforce learning by running theoretical virtual portfolios and keeping a diary in which you state your reasons for buying or avoiding particular assets – whether they are in real or theoretical portfolios. Reading this back after every few months will show what mistakes you made and whether there’s a pattern to them, and force you to ask why you were wrong and when. This should make you a better investor – as long as you are honest with yourself. 

By starting to invest young you’ll get into the habit of saving and benefit from the power of compounded returns. But it's not just returns that compound over time –fund managers’ fees do too. An extra half percentage point of charges could easily cost you over £200 for every £1,000 you invest over 20 years.

This is not a problem if the relatively higher fees are accompanied by higher returns. Funds such as TB Evenlode Income (GB00BD0B7C49) have made higher returns in recent years, thanks to holdings in defensive stocks such as Unilever (ULVR) and Diageo (DGE), and Fundsmith Equity (GB00B41YBW71) due to holdings in US technology companies.

But, as Andrew Lo, professor of finance at Massachusetts Institute of Technology, has shown, most investment strategies wax and wane over time. If these past successes fade, these funds will either have to pivot to new strategies, which is very difficult, or their fees might not be accompanied by decent returns.

You are right to favour defensive stocks. Evidence from around the world for decades shows that, on average, these beat the market over time, although – as with all strategies – experience periods of underperformance. You can get exposure to larger defensive stocks via many investment trusts such as City of London Investment Trust (CTY), which has an ongoing charge of only 0.36 per cent or Finsbury Growth & Income Trust (FGT). 

You plan to have a large allocation to bond funds, and if you don’t want to lose more than 8 per cent in a year, you will need some non-equity assets. But you pay a heavy price for such insurance in terms of foregone returns. Bonds offer negative real yields and could lose a lot if a cyclical upturn causes investors to dump safer assets. Such an event would result in good returns on equities. But, as your equity holdings are less cyclical and high-beta than many others, you’d gain less in such a scenario.

This is not to say that you’re wrong. It’s perfectly possible that markets are more than fully discounting next year’s economic recovery and might be disappointed by its pace. And as a long-term strategy a defensive equity tilt is right. Just be aware that such bond holdings might be a drag on your portfolio’s overall return.

Emma Wall, head of investment research at Hargreaves Lansdown, says:

Your proposed investments are not a bad selection at all. The equity funds – TB Evenlode Income and Fundsmith Equity – are solid, with good geographic and asset class diversification. They have a quality bias, but with strong investment philosophies and robust processes.

Allianz Strategic Bond (GB00B06T9362) has delivered incredible short-term performance and is up 30 per cent in the past 12 months. But this has been achieved through the use of derivatives – complex financial instruments that add risk. And Allianz Global Investors says that this performance is highly unlikely to be repeated. So consider a strategic bond fund with a more cautious outlook such as Jupiter Strategic Bond (GB00BN8T5935).

Ninety One Diversified Income (GB00B2Q1J923) is a multi-asset fund that benefits from a well-resourced team and historically has done well at protecting on the downside. The past year is a case in point – the fund delivered [a total return of 4.1 per cent over the year to 15 December. But it is not without its biases – it has a value-tilt within its equity holdings due to the income mandate. Ninety One Diversified Income had a substantial chunk of its assets in Europe ex UK at the end of November – 17.6 per cent. But this balances Fundsmith Equity, which had 67.9 cent of its assets in US equities, and TB Evenlode Income, which had 82.1 per cent of its assets in UK equities, at the end of November.