Achieve your desired return with less risk

They own rental properties that generate an income of £8,000 to £9,000 a year, as well as their main residence. And Huw has money purchase pension funds, and a frozen final salary scheme worth about £180,000 which should pay him about £5,000 a year. But he is concerned that his pensions could breach the lifetime limit.

"I have received an inheritance that has increased the value of the non pensions accounts by 40 per cent, and the number of holdings from 27 to 61. I would like to use the windfall to be able to change my work/life balance sooner than anticipated. Within the next five years when all the kids have flown the nest, or at least by age 60, I would like to be able to replace my salary and attain a net income of £50,000 a year from our investments to maintain our standard of living.

"My ideal plan would be to work less and travel more with my wife, perhaps taking a year out by the time we reach 54, and repeat our world travels of 30 years earlier.

"My investment objective is to prioritise growth over income as I have sufficient current disposable income from my salary. I have also set aside savings for my three children’s further education. Although in recent years I have seen above-average returns I am happy to achieve a long term annual average of 5 per cent.  

"On a risk scale of one to five I rate myself four, and could tolerate short-term losses of up to 30 per cent. I understand the fluctuating nature of stock market investments so do not try and time the market, but rather drip-feed my savings into investments. I am able to save enough from my income to use the annual individual savings account (Isa) and pensions allowances.

"I am trying to consolidate our non pensions portfolios to around 25 and have recently sold Centrica (CNA) and International Personal Finance (IPF). I think being diversified more evenly across asset classes and having less exposure to the UK would help balance the portfolio. I would like to know how best to rationalise the portfolio to a more manageable level, and reduce unnecessary risk and duplication.

"As I have learned more about investing I have changed my approach. I now research businesses more, and increasingly invest in businesses and funds I understand and which resonate with me. My engineering science background in business helps me to do this.

"Although I mainly take a buy-and-hold approach I have the money available to take opportunities. For example, I bought Persimmon (PSN) shares immediately after the Brexit vote and subsequent drop in construction stocks, and now have a paper gain of over 40 per cent. 

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:

Your portfolio is over-diversified, although this isn't the worst mistake you can make as usually over-diversified portfolios perform much like tracker funds. It's just that they do so at unnecessary expense.

One of these expenses is often fund managers' fees. You don't seem to have many expensive funds, so you aren't doing very badly on this front. Nevertheless, there is still the hassle and inconvenience of monitoring such a portfolio as well as the trading costs. What's more, over-diversification means stock-picking is largely a waste of time. If a share accounts for, say, only 2 per cent of your portfolio, then even if it rises 50 per cent – which would be an astoundingly good return – it would add only 1 per cent to your overall portfolio. And that's only one day's decent return.

The solution to over-diversification is to start from first principles. The first question to ask is what should be the division between safe and risky assets?

Ultimately, this is a matter of taste. Your appetite for risk seems high, but you are quite close to achieving your target level of income, which justifies a cautious allocation.

As a rough guidepost, I'd estimate that a 50:50 split between equities, and cash or bonds, would offer an expected real return of around 13 per cent over five years, with around a one-in-five chance of a loss and a one-in-12 chance of a loss of 10 per cent or more. If that return seems too low and you can take the risk, hold more equities. If you can't take the risk, hold fewer equities.

Katharine Lindley, chartered financial planner at EQ Investors, says:

As you are keen to work less and travel more, it is worth maximising pension contributions over the next five years. If you continue to contribute the maximum £40,000 annual allowance into your pension for another 10 to 11 years, with 5 per cent a year growth, the money purchase pot will exceed £1m. When added to the final salary value, it will exceed the Lifetime Allowance which is currently £1m. Any excess is taxed at higher rates so it is important to keep this under regular review.

You want to draw £50,000 a year net from your pensions and investments by age 60, and may look to reduce work in five years. With investments, cash and money purchase pensions currently worth around £1.4m, allowing for future savings and growth, you should be able to fund your retirement without the risk of early capital erosion. 

Make use of your capital gains tax (CGT) allowance each year, which is currently £11,300. 

You and your wife should also continue to use your Isa allowances each year. If you are a higher-rate taxpayer it is worth holding the highest income yielding investments in Isas to minimise tax.

Increasing your diversification, holding income funds in Isas and maximising the use of the annual CGT allowance should enable you to draw money in a tax-efficient manner.  As pension funds are not subject to inheritance tax, we would generally recommend drawing from taxable general investment accounts, then Isas and then pensions. But your pensions may need to be accessed sooner if you reach the Lifetime Allowance. 

Rachel Winter, senior investment manager at Killik, says:

Your desired return of 5 per cent a year is realistic, and it is entirely feasible that you will be able to generate an income of £50,000 a year from your investments from the age of 60.

If you can accept short-term fluctuations of 30 per cent then you understand and are comfortable with the risks of investing solely in equities. But I think you could still achieve your desired return while taking less risk. If you added some non-equity investments to your portfolio it should lower overall volatility. For example, many real estate investment trusts (Reits) and infrastructure funds offer inflation-linked income yields plus the potential for capital growth.

HOW TO IMPROVE THE PORTFOLIO

Chris Dillow says:

You need to consider what sort of safe assets you should hold. Government bonds would do well in some sorts of equity sell-off, for example, if fears of a recession increase. But they are riskier than cash in that they'd do badly if the market were to expect higher interest rates than it does now. Corporate bonds – at least lower-grade ones – are not safe but offer higher income as a reward for taking on cyclical risk.

Then consider what your equity holdings should be. The default here should be a global tracker fund which is, in effect, a low-cost fund of equity funds. I would sell actively managed funds and switch the proceeds into such a tracker.  

You could add some defensives to this. The case for doing this is not so much that they'd protect you in a downturn, but that on average they tend to outperform over the long run. You already hold lots of these, including via some of your investment trusts such as Finsbury Growth & Income (FGT). I reckon these are worth holding over the longer run.

You've added cyclicals to these, in the form of housebuilders. I've no big beef with this in the near term. Just be aware, though, that holding these incurs the risk of them underperforming if or when the market starts to fear a downturn. I doubt whether any investor could get out in time.

Overall, though, I wouldn't worry about this portfolio. It's on course to hit your objectives, and it's basically sound. It just needs tidying up.

Katharine Lindley says:

Although you consider that you have a risk appetite of four, on a scale of one to five, it is worth considering the overall asset allocation of your pension and investments. The pension is 100 per cent allocated to equities and around 95 per cent of the investments held outside your pension are in equities. We would recommend diversifying into other assets such as fixed income, commercial property and alternatives, and to cap your equity exposure at around 70 per cent. 

Reducing the number of portfolio holdings to around 20 with allocations of about 5 per cent to each, would be a sensible target. We recommend using collective investments rather than direct equities to simplify portfolio management. Those who invest directly in equities need to constantly monitor company statements for issues that could affect the share price. Using collectives reduces the time you need spend on research.

Rachel Winter says:

I agree with the concept of investing in companies that resonate with you as this means you are more likely to take an active interest in your portfolio. That said, this can sometimes lead to an excessive focus on particular sectors, and I note that you have a high proportion of your capital invested in housebuilders. No doubt you will have profited from this, but the size of the position concerns me. The Bank of England has predicted that the UK economy will slow as we approach Brexit, and the housebuilding sector will be particularly susceptible to this as it is so domestically focused. The industry has also been criticised recently for unfair leasehold practices, and the political implications and potential liabilities relating to this are not yet clear. And many housebuilders have become heavily dependent on the Help to Buy scheme which finishes in 2021. Persimmon, for example, currently attributes over 40 per cent of its new house sales by volume to the scheme.

Given the low growth forecasts for the UK economy in the short term, I would advocate buying some overseas equities. You lack exposure to technology and healthcare, and I would look abroad for these.

You also have no commodities exposure. Admittedly, this has been a particularly volatile sector in recent years, but there is a compelling case for investing in the producers of the commodities that are needed for electric cars and batteries, such as copper and lithium.

Your financials weighting is about right but the shares you hold are very dependent on the UK. I'd switch into some alternatives with more international revenue streams.

Funds and investment trusts are great for gaining exposure to areas in which you lack expertise or market access, such as emerging economies. However, they have management fees and I would question whether you need to own so many investment trusts that focus on developed markets, given that you already have a diversified equity portfolio.