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Your portfolio is at odds with your capacity for loss

Our readers need to reassess their risk appetite and allocate their portfolio accordingly
July 5, 2018, Laith Khalaf and Angela Murfitt

Steve is 63 and retired in August 2017 after running an automotive parts business in France for several years. He will start receiving the state pension in three years, which together with his wife's pension should pay £15,000 a year. In the meantime, they need to generate income from their portfolio, although he has not yet drawn from it and will not need to for the rest of this year.

Reader Portfolio
Steve 63
Description

Sipp and Isas invested in funds and shares, property, cash 

Objectives

£35,000 a year income, and money for holidays and cars

Portfolio type
Investing for income

Steve's wife has not worked for years but has an income from a workplace pension of £2,000 a year.

Their home is mortgage free and worth around £430,000.

"I want an income of £35,000 a year from sources including the state pension, plus money to fund purchases such as cars and holidays, which we are likely to spend £20,000 to £30,000 on every five years. We are also considering moving house and may need around £100,000 of our capital to fund this.

"I maximised contributions to my self-invested personal pension (Sipp) during my last three years of work, and have recently started to drawdown the tax-free cash entitlement which I am investing in our individual savings accounts (Isas). I intend to do this every tax year until all the tax-free cash is in our Isas.

"We don't have children so I want to use our wealth to enrich our lives and travel while we are still able, and fund care if necessary later on. If anything is left over we will leave it to our nieces and nephews.

"I have been investing for 30 years on and off, initially as a hobby and then for retirement savings. As I am investing over a long period of time and experienced huge reductions in the value of my investments during the financial crisis, I am fairly relaxed about making a few mistakes and riding out corrections. But as I am no longer contributing to my Sipp I wouldn't want to lose more than 10 per cent of the value of our investments in any one year. I could tolerate this as I keep cash worth at least one year's living expenses.

"I am a growth investor, but reluctantly acknowledge the need for income investing and defensive stocks. If I pick a winner I try to let it run and get very excited if a small punt increases in value. But these days my 'punts' can be worth up to £30,000 so I am far more anxious about them.

"I read the financial press, and often look at broker or newspaper tips for ideas, but do my own research as much as possible before investing.

"My best investment by far has been equipment rental company Ashtead (AHT), which I first bought in 2014, and topped up in 2015 and 2016 after listening to broker presentations online. I thought it was seriously undervalued given the strategic turnaround the company's managers were implementing. My second-best investment has been Marlborough Special Situations Fund (GB00B907GH23).

"I sold Neptune UK Mid Cap Fund (GB00B909H085) in March and reinvested the proceeds in Scottish Mortgage Investment Trust (SMT). I have also recently  bought Segro (SGRO) and Relx (REL) as longer-term, slightly boring, steady investments. I bought Baillie Gifford Emerging Markets Growth (GB0006020647) and Legg Mason IF Japan Equity (GB00B8JYLC77) as more racy positions. And I put a small amount into communications company Huntsworth (HNT) but will sell it if it drifts sideways.

 

Steve and his wife's portfolio
HoldingValue (£)% of the portfolio
MI Chelverton UK Equity Income (GB00B1FD6467)98,0489.89
Marlborough Special Situations (GB00B907GH23)98,0129.88
Fundsmith Equity (GB00B4MR8G82)66,4336.7
Ashtead (AHT) 58,2325.87
Scottish Mortgage Investment Trust (SMT)53,9595.44
Marlborough Multi Cap Income (GB00B908BY75)52,9895.34
Lloyds Banking (LLOY)45,9784.64
Marlborough UK Micro-Cap Growth (GB00B8F8YX59)42,5234.29
Legal & General (LGEN)38,1513.85
Standard Life UK Smaller Companies Trust (SLS)35,4703.58
JPMorgan European Investment Trust (JETI)33,1763.35
National Grid (NG.)33,0273.33
Standard Life Investments UK Smaller Companies (GB00BBX46183)28,6652.89
Royal London Sterling Extra Yield Bond (IE00BJBQC361)27,1852.74
Bovis Homes (BVS)26,9102.71
Legg Mason IF Japan Equity (GB00B8JYLC77)20,0352.02
LF Lindsell Train UK Equity (GB00BJFLM263)19,8692
Standard Life Equity Income Trust (SLET)19,8002
Jupiter India (GB00BD08NQ14)17,5311.77
Diverse Income Trust (DIVI)16,0521.62
F&C Commercial Property Trust (FCPT)14,7301.49
Biotech Growth Trust (BIOG)14,4801.46
Acorn Income Fund (AIF)13,9461.41
Baillie Gifford Emerging Markets Growth (GB0006020647)13,0621.32
Segro (SGRO) 11,0941.12
Old Mutual UK Smaller Companies Focus (IE00BLP58G83) 10,2401.03
Relx (REL) 9,3570.94
Foreign & Colonial Investment Trust (FRCL)9,1930.93
Huntsworth (HNT) 5,1140.52
Cash58,5005.9
Total991,761 

 

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:

This portfolio will probably fulfil your requirements. It is reasonable to expect equities to deliver an average total return of around 5 per cent a year. This should give you almost £50,000 per year in capital gains and income – more than enough to cover your likely outgoings. And because you are happy to run down your wealth you have a lot of capacity to cover shortfalls that may occur due to poor returns or care costs.

So fundamentally you have no overall problem.

But you are no longer contributing to your Sipp which means your portfolio is riskier for you than it used to be. When you are working and saving you can, in effect, hedge against stock market losses with your labour income which you can use to top up your wealth. But when you are retired you lose this hedge.

One solution is to treat retirement as a time for running down your wealth. For most of us, this is a tricky psychological transition – having spent decades building up wealth it's difficult to let go of it. Another solution is to hold more cash – although you sacrifice potential returns you also avoid large falls in the value of your wealth.

You like to run winners and get excited by seeing a small punt rise in value. From an economist's point of view, this is partly wise and partly not. It's good to run winners as, generally speaking on average, there is momentum in share prices.

Getting excited, however, is less wise and not just because emotions are dangerous for investors. If a shareholding only accounts for around 1 per cent of your portfolio, even if it doubles – which would be a tremendously good result – it would add only 1 per cent to your wealth. For your portfolio as a whole, this is only the difference between a moderately good and moderately bad day's return.

You wouldn't get excited by the latter, so why get excited by a small punt rising in value? I suspect because one vindicates your judgement but the other doesn't. For many people, investing is about ego as well as money. But it can be dangerous to interpret past success as a reason to take riskier positions.

However, this portfolio seems to be avoiding this error, so make sure it continues to.

 

Laith Khalaf, senior analyst at Hargreaves Lansdown, says:

Overall your finances seem in good shape as you enter retirement and start reaping the benefits of all those pennies you have squirrelled away over the years. Your portfolio is big enough to generate an income of £35,000 a year, although at the moment I suspect it's falling some way short of that because of all the growth investments you hold.

There are three ways to address this.

You could shift more of your portfolio into income-generating investments – a simple way to boost the yield. But this may mean your portfolio is less diversified and wouldn't hold the growth investments you like.

Another option is to take capital gains from your portfolio each year to supplement the yield. The problem with doing this is that you erode the capital and reduce the portfolio's income potential further down the line, plus there's the thorny issue of when to sell. So this should probably be a last resort at the moment.

You could use the tax-free cash you have withdrawn from your pension to supplement your income until your state pension kicks in. If that's not enough, you would need to make further withdrawals but they would deplete your capital.

However, a combination of cash management, tilting to income investments and, if absolutely necessary, topping up with sales of your investments, should generate £35,000 a year. Once you start getting your state pension you will be less reliant on your portfolio for income so things should get a bit easier.

 

Angela Murfitt, chartered financial planner at Fairstone, says:

As inheritance tax planning is not a requirement, your strategy of taking partial crystallisations from your pension to fund Isas seems sensible. You are positioning your tax-free lump sums to potentially generate tax-free income when you need it, which will help with your overall objective of generating income and occasional capital sums in the future. Your income target is not particularly onerous for a portfolio of this size, so you seem to be in a good position to achieve your objectives.

The current structure of your portfolio is at odds with your capacity for loss of 10 per cent of its value in any one year. As you are no longer contributing to your pension you are not benefiting from the long-term effects of volatility when purchasing funds and shares, but are exposed to the full negative effects of this, should it occur. A portfolio invested in this way is likely to be significantly more volatile than your 10 per cent limit over time.

However, if you increase your allocation to low-risk assets and cash, although they will be a drag on performance in good times, in poor market conditions they will dampen the portfolio's volatility. This would also help to manage some of the unnecessary apparent risks in your portfolio as it currently stands.

 

HOW TO IMPROVE THE PORTFOLIO

Chris Dillow says:

You own lots of proper stock-picking funds such as MI Chelverton UK Equity Income (GB00B1FD6467), Scottish Mortgage Investment Trust, Fundsmith Equity (GB00B4MR8G82) and Marlborough Special Situations. But there might be a downside to owning so many of these.

Diversification cuts both ways. It reduces your exposure to idiosyncratic risk leaving you only with market risk. When you buy a stock-picking fund, however, it's presumably because you want exposure to idiosyncratic risk – the chance that its manager will beat the market. But if you hold lots of stock-pickers you risk diluting that chance away, leaving you with a return similar to that of a tracker fund but with higher fees.

Your biggest funds have outperformed in recent months. However, this suggests that they are positively correlated with each other so might also be positively correlated on the downside if market conditions change. This could happen because of investors wising up to risk – they cottoned onto the fact that some stocks were underpriced months ago and have now driven their prices up too high.

 

Laith Khalaf says:

Your portfolio is out of kilter with your risk tolerance. If you plan to hold your investments for the long term it's good if you have a high risk tolerance. But you are only willing to lose up to 10 per cent in any one year. I don't have a crystal ball any more than you do, but with your current portfolio you should be prepared to sustain an annual loss of nearer to 20 per cent in a bad year, and to go through two consecutive bad years. That is the type of risk that is inherent in the equity market.

So reassess how much you are willing to lose in the short term in search of long-term gains. If you are not able to do this, then I would suggest taking some risk out of your portfolio by switching from equities into more conservative assets such as multi-asset funds.

You won't be able to boost your pension from earnings any more, and as you gradually take money out to spend you will also reduce the future potential of your portfolio. You're entering a great time of life when you can be a bit more footloose and fancy free, but to finance this it's probably best to err on the side of caution with your portfolio.

 

Angela Murfitt says:

It is good that your portfolio has a number of holdings which, in some respects, help with diversification. However, it has a predominant UK bias and lacks asset diversification as it is mainly invested in equities. This means that many of the holdings are correlated and will be likely to move in the same direction when certain market events occur. 

This can have implications for the portfolio volatility's as markets progress through their cycles over the coming years. Although this might be less of an issue during the accumulation stage, it becomes a priority during the decumulation stage. This is because poor market conditions can cause pound cost ravaging – a massive depletion of capital values - if assets are encashed to provide income or capital sums when markets are depressed. For example, a portfolio that falls 10 per cent will need to rise over 11 per cent to get back to the starting point, and a fall of 20 per cent needs a growth of 25 per cent to do this.

You can avoid this happening by diversifying across both UK and global equities, bonds, commercial property and alternative investments in moderate proportions. It is equally important to have sufficient cash and liquidity in your portfolio to cope with short-term market fluctuations. So I would suggest having more cash or equivalent assets than the £100,000 you need in the short term for a house move, to protect your portfolio from unnecessary exposure to market risk.