Max your tax allowances

"The thought of tying money away for a pension before buying a home seemed absurd, but now I feel the need to make up for lost time," says Ruby. "My shorter-term goals are to generate some capital to help pay down some of my mortgage – I would like to make a first lump sum payment in five years. I will also be supporting my mum financially in five years' time and would like to be able to give some money to my sister towards a deposit for a flat.

In the longer term, I am aiming for steady income of 4 per cent a year.

My dad's investing enabled him to retire early though he used to favour high-risk tech stocks. I would also like to be able to retire early but hope to avoid the heavy losses he incurred when the dot.com bubble burst – I prefer modest portfolio growth. I would say that my attitude to risk is low to medium – I understand that I am young and can weather some financial hits but I'm still cautious. This is mainly because I don't have confidence in my ability to pick the right stocks and funds, so I tend to invest in well-known funds.

I favour funds over shares as I have generally not incurred heavy losses with them, but there is an overlap in the holdings of some of my funds. The last three investments I bought were iShares Emerging Markets Equity Index Fund (GB00BJL5BW59), Legal & General All Stocks Gilt Index Trust (GB00BG0QNW27) and Sirius Minerals (SXX). And I'm thinking of investing in Lindsell Train Global Equity (IE00BJSPMJ28).

My Next (NXT) shares were acquired via a share save scheme at £9 a share, and they have provided great dividends and earned back their purchase price. But I'm suffering losses of 10 per cent to 20 per cent on my holdings in Barclays (BARC), Centrica (CNA), Dunelm (DNLM) and Domino's Pizza (DOM)."

Ruby's portfolio

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

THE BIG PICTURE

Chris Dillow, Investors Chronicle's economist, says:

I'm not sure whether you should fret about paying off some of your mortgage.

The case for doing this is that mortgage rates are higher than cash savings rates, so reducing your mortgage is more efficient than cash savings. The case for not doing this is that your pension contributions get tax relief whereas the same money used to pay off a mortgage doesn't. And it's likely, though not certain, that equity returns will exceed the mortgage rate, so you can use compound returns to pay off the mortgage later.

Tamsin Hazell, chartered financial planner at Succession Group, says:

You would like to build up a pot to help pay down your mortgage in five years. Due to the fluctuating nature of invested capital, the minimum investment period I suggest is five years, and a low-risk strategy is likely to be appropriate. Or, instead of investing, have you considered making regular monthly over payments to your mortgage? The difference between your mortgage interest rate and the expected annual investment return will be key to your decision.

Importantly, you should be entirely comfortable that your arrangements are affordable and that you have enough cash for a rainy day.

You have concentrated on saving for your first home until recently, so now is a great opportunity to make further provision for your financial future. Saving into a pension, an investment wrapper that can sit alongside the rest of your portfolio, is a good start. All your savings and investments will ultimately contribute to your financial security.

A significant advantage of a pension is that your savings will be topped up by government tax relief. Using your annual individual savings account (Isa) allowance will also provide a tax-friendly home for your money. Regular investment will help you benefit from pound-cost averaging – the process of spreading the point at which you enter the market.

James Norrington, specialist writer at Investors Chronicle, says:

The first thing to check is whether you are making the most of all of the tax allowances and benefits that are open to you. Are you fully opted into your workplace pension scheme? You should pay in the amount that will get your employer's maximum contribution. This is free money which is grossed up – the total pension contributions earn you income tax relief – so you receive back money you would have paid in tax.

With the investments you are managing yourself, your first port of call should be your annual tax-free Isa allowance, which is currently £20,000. And if you save £4,000 of this a year into a Lifetime Isa the government will add £1,000 for each year up until age 50, although you cannot withdraw this without incurring a penalty worth 25 per cent of the value of your pot until age 60. But this would incentivise you to stay invested over the longer term to build up retirement savings.

If you can afford to save more than £4,000 a year into Isas, then a separate stocks and shares Isa to use up some or all of the rest of your allowance would also be useful.

With interest rates low, I question the need to pay down the mortgage quickly. If you can borrow cheaply then the opportunity cost of the returns you'll miss out on is higher than the cost of capital on your home. If rates get hiked by the time you come to renew your mortgage then you may want to pay some of it down, but if we're still in a low rate environment your overall life goals may be better served by staying invested. Hopefully, your earning power will increase in the next few years, too, meaning the size of the mortgage will seem less daunting.

HOW TO IMPROVE THE PORTFOLIO

Chris Dillow says:

Your biggest asset isn't any of the holdings in this portfolio – it's time. The fact you've started investing young means you have time on your side so you can benefit from compound interest. For example, if equities give an average annual return of 5 per cent per year in real terms, which is uncertain but not fanciful, then every £1,000 you invest today will grow to over £3,700 by the time you're 55. Someone who invests £1,000 at the age of 35, by contrast, will make £1,000 less by that age.

However, compounding can also work against you because fund managers' fees also compound. If you pay a percentage point more than necessary in fees, then over 20 years each £1,000 invested with fund managers will cost you over £400, assuming a 5 per cent return on equities. That's almost half the original investment.

I would, therefore, warn long-term investors against holding many actively managed funds. Of course, it's possible that one or two might outperform over the long run, especially if they are backing proven strategies such as defensive stocks. But it's less likely that 10 will do so. So holding lots of active funds risks achieving worse performance than a tracker fund because fees will subtract from returns. In the long run, a global tracker fund is a better bet than a basket of active funds.

It's also a better bet than specific stocks. Over 20-plus years even good stocks are at risk of being on the wrong side of creative destruction. They could be devalued by technical change or competition. In fact, the healthier and more dynamic the economy is, the greater this risk is. So I'd prefer a tracker fund to your stock picks.

This isn't to say those picks are disastrous. Dunelm and Next are bets on a turnaround and against momentum – which are dangerous plays. But stocks such as Vodafone (VOD) and National Grid (NG.) are the sort of defensive stocks with some monopoly power that have traditionally done well. And you've mostly avoided what is a common mistake among younger investors – putting money into speculative growth stocks.

You say you lack the confidence to pick the right stocks or funds but it's not just you – nobody can be confident about the future. So a global tracker fund is the answer – it backs the field rather than any specific horse.

A tracker fund also makes it easier to manage risk. A way to avoid the sort of losses your father suffered in the dot.com bust is to follow the rule of selling when shares fall below their 10-month average. This protects you from long bear markets and it's easy to follow this rule with a tracker fund in a pension.

Tamsin Hazell says:

When choosing an investment strategy, consider your natural preference for risk, need to take risk, and ability and willingness to cope with investment loss.

As you are in your 20s your pension will be invested for the long term. To position your pension savings to achieve healthy returns, consider adopting a slightly higher-risk strategy than your cautious nature instinctively allows. Your investment time horizon should enable you to ride the ups and downs of markets, and capture the long-term growth equity investing has historically offered.

An appropriate strategy for your investment portfolio will largely depend on what this money is for. The general rule is the shorter the timescale, the less risk you should take. This is to minimise the chance of investment losses.

Equities typically carry higher risk than fixed-interest securities, but diversification across asset classes, sectors and geographical regions  helps mitigate the risk of overexposure to a particular area. Consider the effect of charges, and implement a cohesive strategy across all your funds and shares to avoid too much overlap in underlying stocks.

James Norrington says:

The weightings of the investments need to be more balanced, especially as you are not comfortable taking a lot of risk; 27 per cent of your portfolio is invested in Next which is too much in any one holding – especially a highly cyclical retail stock. Next has also taken a bit of a pounding over the past year.

Given your stated risk appetite and the size of your portfolio, you might be better off investing in collective investment vehicles rather than lots of small holdings in individual shares. You could consider managed funds or cheaper tracker products such as exchange traded funds (ETFs). With these you can spread the risk of investing across different asset classes and regions, and either rely on the skill of a manager to search out special situations or gain broad passive exposure to whole markets through an index tracker.

You are heavily invested in equities, including some speculative smaller stocks, so you need to consider your approach to asset allocation. Shares seem to offer the best reward for risk at the moment but a balanced portfolio should include other asset classes in case the outlook for equities darkens.

The difficulty is that after years of quantitative easing and historically low interest rates, safer investments such as government bonds are at record prices and pay rock-bottom yields. There is the danger of a negative real return after inflation because bond prices and yields move inversely. But short duration government bonds, which will fall less in price if interest rates rise, should form part of your portfolio. Over time these will provide greater security for capital and may help your portfolio suffer less of a peak-to-trough fall in value during bear markets. You can invest in short duration government bonds cheaply via an ETF.

For your equities exposure, buy a selection of funds that give you broad regional exposure. As well as funds that buy UK companies, consider ones that invest in developed markets such as the eurozone and Japan. And while you can't ignore the US, be cautious what percentage of your portfolio is invested there given the high valuations.

Regions such as developing Asia are expected to outperform over the long term, but there are times when this can be a bumpy ride. So, while you shouldn't invest too high a proportion of your total capital in this area, you should have some exposure, either through a vehicle that tracks a broad and diverse index of companies or a managed fund to take advantage of a specialist's knowledge.