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Address the issue of concentrated risk

Our readers should broaden their mix of holdings and use Isa wrappers
May 24, 2018, David Henry and Nick Lamb

Mick is 34, and he and his wife have a net household income of at least £100,000 a year. They own their home which is worth about £800,000, on which they have a £500,000 mortgage with 26 years left to run. They have one young child, and hope to have another soon.

Reader Portfolio
Mick 34
Description

Shares, cash, precious metals, property, wine, art

Objectives

Grow portfolio to £1m in 26 years to pay out income of 3% to 4% a year

Portfolio type
Investing for growth

"We put about £15,000 to £20,000 a year into our employer pensions, including additional contributions, but I have no idea how much our pots are worth," says Mick. "We would like our investment portfolio to have a value of about £1m in 26 years as I hope to retire at age 60. I would like it to pay out an income of 3 per cent to 4 per cent a year.

"I reinvest all of the dividends I get from the investments in my trading account and invest £2,000 to £5,000 new capital a year. 

"I have been investing for around seven years and would say that I have a medium to high attitude towards risk. I would be prepared to lose up to 20-30 per cent of our portfolio's value in any given year.

"I invest in businesses that impress me as a customer or do something different, and I sell holdings when I am unimpressed as a customer. I use Twitter to gauge customer sentiment towards companies and brands. I also do some high-level research, but would not say I am driven by the detail and the numbers in my decision-making process.

"I have invested heavily in the travel industry and this has been successful. I believe that this industry will continue to enjoy robust growth, and have recently invested in Norwegian Air Shuttle (NAS:OSL) and International Consolidated Airlines (IAG). These were purchased a few weeks before International Consolidated Airlines was reported to be considering taking over Norwegian Air, which I didn't expect, so was lucky. I saw Norwegian Air as a boom or bust investment that would make a comeback or die.

"I am also considering investing in easyHotel (EZH). But I appreciate that there is significant risk relating to this cyclical industry so would like to reduce my exposure to it soon, and have recently sold Ryanair (RYA). I am also considering investing in Tesco (TSCO) and Iomart (IOM)

"As well as our equity portfolio, we own wine worth £15,000 to £20,000, which we hope to drink someday, and art worth £20,000 to £30,000. We also have £15,000 in gold, £9,000 in silver and £6,000 in palladium."

 

Mick's portfolio

HoldingValue (£)% of the portfolio
International Consolidated Airlines (IAG)14,931.627.82
Ferrari (RACE:MIL)4,446.122.33
Wizz Air (WIZZ)13,358.467
Just Eat (JE.)17,906.429.38
Arbuthnot Banking (ARBB)2,637.121.38
Aviva (AV.)3,155.701.65
Baron Oil (BOIL)50.920.03
Dart (DTG)7,743.864.06
Lloyds Banking (LLOY)3,358.041.76
Norwegian Air Shuttle (NAS:OSL)29,575.1415.49
Smurfit Kappa (SKG)13,743.047.2
Gold150007.86
Silver90004.71
Platinum60003.14
Cash50,00026.19
Total190,906.44

 

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

 

THE BIG PICTURE

Chris Dillow, Investors Chronicle's economist, says:

You're doing two major things right: saving a lot regularly and reinvesting dividends.

Reinvesting dividends matters because it's likely that most of the long-run returns on shares will come from dividends rather than growth. This is for a simple reason. Average yields, for example 3.7 per cent on the FTSE All-Share index, exceed likely gross domestic product (GDP) growth of maybe 2 per cent. This means that if dividends grow in line with GDP over time and share prices in line with dividends, then capital growth will only be around 2 per cent. So dividends will account for most future returns.

The opposite will only happen if dividends and, by implication, profits rise as a share of national income or valuations rise. Both are possible in the short term, but less likely over the long run.

However, I'm puzzled as to why this portfolio isn't held in a tax-efficient wrapper. It should be in an individual savings account (Isa), as making sure you don't pay unnecessary tax is one of the most important things an investor can do.

You have no idea what your pension is worth, so find out. And you don't say whether your pension is defined-contribution and, if so, in what it is invested, or defined-benefit (final salary). This difference matters. If you have a defined-benefit pension you might be able to afford to take on more equity risk in other investment accounts because this type of scheme carries less. It'll only take you a few minutes to find this out.

 

David Henry, investment manager at Quilter Cheviot Investment Management, says:

I would recommend that both you and your wife both use your annual Isa allowances. Your joint allowance for the current tax year of £40,000 is material in the context of the portfolio. And in a world where forward returns on asset classes are expected to be low relative to history, ensuring that your net return is as high as possible is very important.

Given the strong financial position that you are in, it is likely that when you come to retirement your estate will have grown to a size where it will be subject to inheritance tax. So it may be worth drinking some of that wine before then.

As you have been investing for around eight years your experience is based on a broadly positive period for equity markets. But your equity portfolio is extremely concentrated, so I would be concerned that in a protracted bear market your paper losses would be in excess of the 20-30 per cent level you say you would be comfortable with.

You have exposure to other assets which may reduce your overall risk, but nonetheless you need to consider how you might react when markets turn.

 

Nick Lamb, investment manager and head of WH Ireland's Bristol office, says:

A young growing family is expensive, as is paying off a significant mortgage. So to try to get your investments to hit a target of £1m in 26 years, it is essential that you have a regular savings plan that you review often to ensure that the objectives and needs are on track.

The right collection of investments could yield 3-4 per cent, although this is maybe at the higher end of what is possible. So get some professional advice and establish your objectives, appetite for risk and capacity for loss. Every investor has different needs and objectives.

Your strategy should include using tax-efficient wrappers to mitigate potential capital gains tax. If you and your wife make use of your annual Isa allowances, which are currently £20,000, and contribute to your pensions, your goals could be achieved. You have a long enough time horizon over which to save towards your goals, although whether you achieve them will depend on your investments' returns, which can be volatile and variable – particularly if you have exposure to equities.

 

HOW TO IMPROVE THE PORTFOLIO

Chris Dillow says:

This portfolio's heavy exposure to airlines means you are taking lots of cyclical risk – even the best-managed airlines will suffer more than most in a recession.

We have one warning sign of a global recession: the shape of the US yield curve. When yields on 10-year US Treasury bonds have fallen below the federal funds rate in the past, a recession has usually followed within months. Unfortunately, though, more investors are now aware of this so they might be quicker than usual to dump cyclical stocks if or when this happens. That means you might not be able to get out at the right time.

But you have some protections such as your cash savings. Another is your precious metals, which might do ok if oil prices surge, another thing that is bad for airlines. And they might do well in a recession, as falling bond yields are often good for gold.

Then there are your future investments. Assuming you and your wife both keep your jobs in a downturn, saving a lot means you'll be able to buy lots of shares when their prices are low and expected returns high.

For these reasons, you're not badly placed to take on cyclical risk. And unless we get a big surprise there's no reason to believe that a global recession will occur soon, so you've plenty of time to adjust your portfolio. Even so, I'd consider lightening exposure to those cyclicals over time.

 

David Henry says:

If you consider adding an alternative to equities I would suggest listed infrastructure. Although it is slightly higher risk than conventional bonds, this sector is trading on a discount due to market concerns about Labour taking private finance initiative (PFI) projects in house if it gets into power. But these real assets pay a predictable and steady income which is often linked to inflation. In view of your and your wife's annual income, if you invest in these higher-yielding investments make sure you hold them in Isas to avoid adding to your taxable income.

As global growth continues to be synchronised and robust, I agree with having a focus on cyclical names. But I would at least diversify the sectors you invest in as over half of your equity investments are in airline operators, which are capital-intensive and highly exposed to commodity prices. If global political tensions escalate a higher oil price would be likely and this would have a knock-on effect on airlines' input costs. 

We like banks and insurance companies because historically they have outperformed when the global economy is performing well, and can act as a natural hedge against rising bond yields. I would consider adding to Lloyds (LLOY), and adding HSBC (HSBA) and Prudential (PRU). 

 

Nick Lamb says:

Your existing mix of investments includes a significant amount of cash, which might be good as an emergency fund. But with low interest rates and inflation around 2.5 per cent cash is likely to be delivering a negative real return.

Physical commodities such as gold normally have custody costs for their safekeeping, so it is important to check what these costs are and how much of the returns they are eating away. Consider investing in exchange traded commodities (ETC) which can give you exposure to physical commodities in a more cost-effective way due to their lower charges.

Art and wine can go both up and down in value, and have different rules on the tax you incur on their gains. There is also the issue of how easy it would be to sell these assets should the need arise, unless of course you keep them and enjoy them.

Investing directly in shares carries the risk of total loss if the companies go bust. However unlikely it may seem, you only have to look at Carillion (CLLN) to realise that this risk is significant. Diversification is essential, and achieving this means ensuring you have invested in a wide enough range of assets, and have exposure to a number of different underlying investments in different geographies.

Exposure to shares for capital growth and income can be achieved in a cost-effective way by investing in collectives such as passive trackers or actively managed funds. Although there is an underlying cost, a lower level of risk can be achieved for broadly the same outcome.