Beware having a false sense of security

"Following my divorce a few years ago, I have had to change from a position of relative comfort with no mortgage and widespread investments, to having a mortgage again," explains Stephen. "In retirement I expect to receive the full state pension and this portfolio will be my other main source of income. It is a consolidation of all my previous employer pensions held within a low-cost self-invested personal pension (Sipp). But future contributions to it are likely to be minimal.

"My current workplace pension is an insurer-based scheme to which I make minimal contributions, so it will only have a small value. I hope that I will be able to go into income drawdown with my Sipp and then pass on whatever is left to my children.

"I have a long-term investment horizon of 10 to 15 years and I am prepared to take risk – if higher risk translates into higher returns. But I couldn't tolerate an overall portfolio loss of more than 15 per cent in any one year and I have cash worth £33,000 in my Sipp. I don't think having cash in my Sipp is a good idea because it has a long-term investment horizon, but over the past two years I have held back from investing in the US as valuations and the market have looked high. And I have avoided bonds as these seem too volatile with interest rates at low levels.

"I have been investing for more than 20 years and started off with a specific bias to UK equity income investment trusts with low charges. Over the past three years I have diversified away from the UK into other markets to spread risk. But I have kept the bias to income.

"I have invested in two exchange traded funds (ETFs) but these seem to have achieved similar performance to the other investments. Other recent purchases include Segro (SGRO) and TR Property Investment Trust (TRY) to add some exposure to the distribution and warehouse sub-sectors in the UK and continental Europe.

"In the past I have been slow to sell investments that are underperforming, but I am wondering whether to sell Dunedin Income Growth Investment Trust (DIG) [which has underperformed the FTSE All-Share index over one, three and five years on a cumulative basis]. However, I am unsure where to reinvest the proceeds if I do sell it."

Stephen'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:

A distinctive feature of this portfolio is your expectation that you are unlikely to make further contributions to it. This means that an equity-heavy portfolio is riskier for you than it would be for someone who does make contributions.

If you were making contributions to your portfolio you could buy when share prices are low. You don't need to time the market to do this – even regular monthly investments buy you more shares when prices are low. In not doing this, you are in effect losing one way of spreading risk.

Does this matter? With average luck, no. If we assume an average real total return of 4 per cent a year – less than the longer-term average – this portfolio should grow to almost £1m in today's prices by the time you are 65. That would easily get you an income of around £35,000 a year in today's money.

There are, however, risks to this scenario. Even over a period as long as 16 years there's a chance of losing money. Based on historic volatility, there's around a one-in-12 chance of you having less in real terms at the age of 65 than you have now.

From this perspective, diversifying overseas is sensible. Doing this will not spread short-term risk as international markets usually rise and fall together. But over longish periods there's a risk that the UK will underperform overseas markets and international diversification helps to protect you from this.

This also means that a decent cash holding isn't a bad idea. Interest rates on cash held in Sipps are generally poor, so ideally your Sipp should be fully invested in equities and your cash should be held elsewhere, such as in an individual savings account (Isa). There's a case for cash because, poor as its returns are, it protects you from potentially big losses.

James Norrington, specialist writer at Investors Chronicle, says:

If your mortgage and family commitments make it impossible to make further pension contributions, assuming you don't exercise pension freedoms and reinvest all portfolio income until you're 65, the annual rate of return on your Sipp to hit the lifetime allowance of £1.03m is around 4.3 per cent. The current yield on UK gilts is 1.4 per cent so, assuming a global equity premium over gilts of just under 3 per cent, hitting this level is not unlikely.

The issue for you is risk and the stage you are at. Holding the lion's share of your portfolio in equities is reasonable if you have sixteen years until you retire but it could be a bumpy ride. In the 2007-09 bear market MSCI World index lost 54 per cent, a level of drawdown you would find especially uncomfortable as you get nearer to retirement.

In theory, you should gradually be changing the asset allocation of your portfolio so you have proportionately less in equities than in lower volatility assets such as government bonds, the closer you get to retirement.

But years of ultra-loose monetary policy by central banks mean that bond prices are very high. The sensitivity of bond prices to interest rate rises means there is a risk of capital loss for bond funds as rates are hiked from record low levels. So for now, consider having around a fifth of your Sipp in short-duration gilts – UK government bonds – and the rest in equities. Duration in years measures the sensitivity of bond prices to interest rate rises. Short-duration bond funds hold issues that are closer to maturity, so their capital value should fall less as interest rates rise. Options include Lyxor FTSE Actuaries UK Gilts 0-5Y UCITS ETF (GIL5).

As interest rates normalise the yield component of bond returns, which moves inversely with their prices, becomes more important and should offer a low-risk rate of return. As you get older, move more of your Sipp into these lower-risk funds to diversify the risk of equity exposure. If your equity investments have a good year you could use this as an opportunity to take some risk off the table by moving into short-duration gilts as your future required rate of return decreases.

That said, one of the advantages of a Sipp is that you don't have to crystallise the whole fund at once. This enables you to ride out periods when the stock market falls and allows the value of your investments to recover, so you don't need to move 100 per cent of your assets into gilts. For your peace of mind, however, it might be best to have a less equity-focused portfolio strategy nearer to the time you'll need to draw an income.

Robert Ward, chartered wealth manager at Walker Crips, says:

If you can only tolerate a maximum 15 per cent drawdown in any one year an allocation of about 87 per cent to equities is too high. We have been fortuitous over the past 10 years in that we have not experienced large losses in equity markets, but such falls will occur again. Do not forget that the FTSE 100 index lost over 40 per cent of its value only 10 years ago, and although I cannot predict when the next major decline in the markets will come, rest assured that at some point it will.

You should not have a false sense of security just because you own lots of different investments, as this does not necessarily equate to a reduction in the risk of your portfolio. Holdings such as HSBC (HSBA), BP (BP.), Royal Dutch Shell (RDSB) and British American Tobacco (BATS) are key constituents of the FTSE 100 index, but these companies feature in the top 10 holdings of more than five of the UK equity funds in your portfolio. So, despite holding different UK funds, the underlying assets are very similar, which is likely to significantly increase your portfolio's risk in turbulent times.

HOW TO IMPROVE THE PORTFOLIO

Chris Dillow says:

Your portfolio is quite concentrated. Your largest holdings are all heavily invested in big, fairly defensive UK dividend payers. For example, Edinburgh Investment Trust (EDIN) and Dunedin Income Growth Investment Trust both have British American Tobacco as their biggest holding.

Historically, this has been very sensible. Defensive high yielders have done well, in part because investors have underappreciated the importance of monopoly power as a means of ensuring sustained profit growth. There is, however, a danger that they have now wised up to this, and that such stocks are fully priced or worse. This doesn't mean you should rush to sell, but do be wary of adding more to this segment.

I'm not enthusiastic about property. This carries cyclical risk – it does badly in recessions. It also incurs liquidity risk as it is difficult to sell in bad times. And I fear that bricks and mortar retailing is in long-term decline, which might put downward pressure on many property values.

You don't have exposure to private equity. It's possible that the best opportunities for long-term growth aren't in quoted companies but in unquoted ones. So private equity investment trusts might give you beneficial exposure to this asset class.

James Norrington says:

Your equity investments have a decent geographic spread. With the US market on stretched valuation multiples, it makes sense to build your own balance of exposures rather than buy a global tracker fund, roughly half of which would be invested in the world's biggest stock market by market capitalisation. You don't want to be totally out of the US, though, and your global funds give you some exposure to that market. Many of your UK funds should also invest in companies that generate a good portion of their revenues from the US, giving you further indirect exposure to that economy.

But don't overdiversify with the result that you have several funds focused on the same region that dilute away each other's gains or differentiating characteristics – especially as you are paying active fees for them. If the overall risk-adjusted performance of your investments covering a given region is less than the index benchmark, rather than having three or four different funds focused on it you might as well hold a tracker fund and save on costs.

Robert Ward says:

It is good that you have diversified your geographical exposure with holdings in Europe, Asia and Japan. You could take this approach further by adding exposure to a number of asset classes other than equities and property. Although you have been cautious because of the volatility in bond markets, there are ways of gaining exposure to bonds via less volatile strategies such as long-short bond hedge funds. This would provide an additional source of return with low correlation to the rest of the portfolio.

I would also suggest diversifying the portfolio into less correlated investments such as infrastructure, fixed interest and market-neutral funds. This would be a sensible way to reduce the overall correlation of the portfolio's returns and protect against large drawdowns – something especially important as you plan to use the portfolio as one of your main sources of retirement income.

Given your risk tolerance and objectives, alternative asset classes such as infrastructure would be a good addition to the portfolio. This asset class has had a tough time so far this year following the demise of Carillion (CLLN), which provided services to projects some infrastructure funds invest in. But there are still attractive opportunities among the assets of infrastructure funds such as BBGI SICAV (BBGI). So we consider the current period of underperformance a good time to buy more.