David and his wife are both 71 and reasonably secure financially. They have index-linked occupational pensions plus the state pension. They have recently transferred a sum of about £470,000 to their daughter who is age 41, which they invested a year ago. She is also reasonably secure financially and should eventually have index-linked occupational pensions plus the state pension.
"We want this capital sum to provide increased security for our granddaughter, who is unlikely to benefit from escalating house prices and a final-salary pension," says David. "My wife and I use the dividends from our individual savings accounts (Isas) to add to our income, and will transfer any surplus to our daughter and granddaughter, who has a Junior Isa.
"The objective for this portfolio is a total return of 7 per cent a year over about 25 years, including dividends of 3 to 4 per cent, which will be reinvested. The dividends will not be reinvested via a dividend reinvestment plan as this creates more complex tax returns. Instead they will be transferred to an Isa, which will be topped up to the annual limit [£20,000 or £4,260 for Junior Isas], if necessary doing a bed and Isa."
Bed and Isa involves selling investments outside your Isa, offsetting any capital gains tax (CGT) incurred against your annual allowance, which is currently £11,700, and then repurchasing the same investments within the Isa.
"If we make profits we also plan to take advantage of the CGT allowance each year via careful sales and purchases," adds David. "We have beeninvesting for about 30 years and the selection of shares in this portfolio largely reflects the holdings my wife and I have built up over a number of years in our own Isas.
"We are willing to take on moderate risk to try to get better long-term returns, but I hope that we will not make a loss of more than 5 per cent in any given year. There is always the possibility of a Carillion (CLLN] type situation, but over the years we have been fortunate enough to stay ahead of the game, with some losses but considerably more gains.
"Our approach is to buy and hold for the long term, which reduces trading costs. Costs are also a reason why we have largely avoided collective funds.
"When choosing shares we try to assess whether a company seems to have good prospects for the coming years, a well covered dividend, and ideally a price earnings (PE) ratio of between 10 and 15.
"But as we age and perhaps are not so easily able to manage a large number of shares, we are considering restructuring the portfolio. We thought we could buy a selection of investment trusts to get exposure to five geographical areas: China, Japan, North America, Europe and the UK – maybe two for each region."
|David's granddaughter's portfolio|
|Holding||Value (£)||% of the portfolio|
|Air Partner (AIR)||7,605||1.58|
|Berkeley Group (BKG)||19,916||4.13|
|N Brown (BWNG)||10,065||2.09|
|Canadian Imperial Bank of Commerce (CM:TOR)||5,722||1.19|
|China Medical Systems Holdings (867:HKG)||11,201||2.32|
|Dairy Crest (DCG)||5,607||1.16|
|European Assets Trust (EAT)||3,930||0.82|
|Fundsmith Equity (GB00B4MR8G82)||4,373||0.91|
|Greene King (GNK)||5,450||1.13|
|Henderson Far East Income (HFEL)||6,643||1.38|
|James Fisher (FSJ)||10,179||2.11|
|Legal & General (LGEN)||14,748||3.06|
|Manulife Financial Corp (MFC:TOR)||5,183||1.08|
|National Grid (NG.)||6,911||1.43|
|Old Mutual (OML)||16,147||3.35|
|Pan African Resources (PAF)||4,475||0.93|
|Reckitt Benckiser (RB.)||11,209||2.33|
|Royal Dutch Shell (RDSB)||6,200||1.29|
|Scottish American Investment Company (SCAM)||3,895||0.81|
|Severn Trent (SVT)||4,408||0.91|
|Taylor Wimpey (TW.)||6,342||1.32|
|Toronto-Dominion Bank (TD:TOR)||6,437||1.34|
|Town Centre Securities (TOWN)||18,544||3.85|
|TP ICAP (TCAP)||3,200||0.66|
|Tritax Big Box REIT (BBOX)||15,065||3.13|
|United Utilities (UU.)||9,836||2.04|
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:
A long-term buy-and-hold strategy might seem sensible but it has a drawback. As you add to your holdings without selling, you can end up with a portfolio that is overdiversified. The contributions of individual stocks are small, so the portfolio, in effect, is an unwieldy tracker fund. And this is what you have here.
In this context, your idea of risk is mistaken. You fear a situation similar to that at Carillion. But in a portfolio of 48 holdings, such as yours, a 100 per cent loss on one share would only lose around 2 per cent of the value of the overall portfolio. That's only one-quarter of the loss we've seen on the general market so far this year.
With a diversified portfolio market risk matters much more than individual stock risk.
And this is bigger than you might think. You hope that the maximum loss in any year will be no more than 5 per cent. But it could be more than that. Since the start of 1988 the FTSE All-Share index has produced an average annual total return of 6.1 per cent, with a standard deviation of 14 per cent. If these numbers are a fair guide to the future, then there is around a one-in-five chance of losing more than 5 per cent over a 12-month period, and a roughly one-in-seven chance of losing 10 per cent or more.
And I suspect these numbers err on the optimistic side. In a world of low growth, average equity returns might well be lower than they have been in the past. If so, the risk of big losses is greater.
Henry Fox, relationship manager at Seven Investment Management, says:
You appear to be making good use of government tax allowances. It is important to be disciplined each year because if you do not use your Isa or CGT allowances, you lose them. Over time, your daughter can move her taxable portfolio into her Isa and therefore build up the majority of it in a tax-efficient environment.
It is great that you have started to save for your granddaughter. Given the powerful effects of compound interest, the earlier you put money aside, the better. You could also consider starting a pension for her with excess income from your Isas. You can put up to £2,880 a year into a pension and this will be topped up by the government to £3,600.
Your family's portfolios are invested in a similar manner to each other, so I would look at the overall picture and decide the part each portfolio plays in your wider objectives for the longer term. This may lead you to allocate the portfolios differently to each other.
Rachel Winter, senior investment manager at Killik, says:
This portfolio is almost entirely invested in direct equities which is a suitable approach for a young person with a time horizon of 25 years. However, while your anticipated annual return of 7 per cent is realistic for a portfolio of this nature, your maximum acceptable loss of 5 per cent is not.
The FTSE All World index has experienced two falls of over 40 per cent during the past 25-year period: once when the dot-com bubble burst and again during the financial crisis. Despite this, an investor who bought on the day before the dot-com bubble burst would be sitting on a significant gain if they were still invested today. Volatility is inherent in the stock market, and those investing for growth over a 25-year period should be prepared to weather the ups and downs. If a loss of 5 per cent is not acceptable, I would recommend aiming for a lower return and allocating a significant portion of the portfolio to more stable non-equity investments.
HOW TO IMPROVE THE PORTFOLIO
Chris Dillow says:
I think you're half-right to consider switching into investment trusts as a way of simplifying the portfolio. When doing this, cut losing stocks and run winners as this will help you benefit from momentum effects. Also, look for good discounts to net asset value relative to a trust's own history. An unusually wide discount can be a sign that investor sentiment is depressed, which signals that the trust is unusually cheap.
However, such a switch is not a panacea. So far this year, the FTSE All-Share index has fallen over 8 per cent, while the US has lost almost 5 per cent, Japan almost 4 per cent, Europe 8 per cent and China 2 per cent. This tells us that national stock markets are highly correlated. They tend to fall together, which makes it difficult to spread risk well by diversifying across countries.
The best way to mitigate equity risk is to hold other assets such as cash, gold or bonds, although the latter has done badly this year. So this poses the question, how much might you want to diversify into other assets? And this question is complicated because you're investing in large part for your granddaughter.
You might think that the long-term time horizon means you can afford to take equity risk. But this is not necessarily the case as the market can fall over long periods. For example, even when you take dividends into account, the market was lower in real terms in 2011 than in 1999. That's over 10 years of losses.
A better argument for a high equity weighting might be that your granddaughter will have earnings of her own. In effect, these give her an asset that helps spread equity risk, though probably imperfectly.
But let's be clear. The question of whether to be fully invested in equities is the most important one for any investor.
Henry Fox says:
Your granddaughter's portfolio is almost totally invested in equities, but you hope that in any given year the maximum loss will be 5 per cent. With such a high allocation to equities, it would not be surprising if the portfolio fell much more than this. The FTSE 100, for example, fell 31 per cent in 2008.
But given the long-term time horizon of 25 years, your granddaughter may be able to endure greater volatility than a 5 per cent loss. So you could keep the majority of the portfolio in equities but diversify some of it into other assets.
The portfolio has a large exposure to the UK stock market. It is extremely common for UK-based investors to allocate in this way. However, the UK only represents about 6 per cent of the MSCI World Index. Although 75 per cent to 80 per cent of the FTSE 100 index's earnings are derived from overseas, you should still consider adding regional diversification.
You are cost conscious, so could diversify your direct stock risk by using some low cost exchange traded funds (ETFs) to get exposure to developed markets. However, when allocating to areas such as emerging and frontier markets, it could be worth paying for active management.
Rachel Winter says:
Focusing on stocks with a PE ratio of 10 to 15 and a dividend yield of 3 to 4 per cent is likely to point you in the direction of some established blue-chip businesses. However, it will also restrict you to certain sectors of the market.
For example, over 20 per cent of the portfolio is invested in financials, and there is also a significant weighting in FTSE 100 healthcare and housebuilding stocks. A focus on high dividends is also likely to result in a bias to the UK, as overseas businesses generally pay lower dividends, instead using profits for share buy-backs and acquisitions. This is preferable as it allows more flexibility, whereas many UK companies have committed to high dividends which they have struggled to pay in times of economic difficulty.
Companies with higher growth rates are often worthy of a premium, and I would recommend including price/earnings to growth (PEG) ratios in your analysis, which essentially incorporate an earnings growth rate into the PE ratio.
You could increase diversification in this portfolio by adding some technology stocks. Microsoft (MSFT:NSQ) and Alphabet (GOOGL:NSQ), which is better known as Google, both have PE ratios of 21x, but have grown their earnings by over 30 per cent during the past year.
Open-ended funds used to charge relatively high fees, but regulatory initiatives mean that since 2013 there have been significant reductions in their charges. This means many open-ended funds are comparable to or cheaper than investment trusts. So I would consider using collective investments to add exposure to high-growth areas in which you might not want or be able to purchase shares directly. Examples include emerging markets such as China and India, and sub sectors such as robotics and artificial intelligence.