Your portfolio doesn’t match your risk profile

"I would like an income of 5 per cent a year and for the capital value of my investment portfolio to keep up with inflation,” says Victor. “The 5 per cent income is to help cover luxuries such as travel. I am investing for hopefully reliable income due to the uncertainty that lies ahead with Brexit and US president Trump's trade wars. My thinking is that if the capital value of my portfolio suddenly decreases at least I will have the income coming in.

"I would rather lose nothing, of course, which is why I have some gold. That said, if things get really bad and I lose everything, I would still be okay, so maybe I could tolerate a loss of 10 per cent.

"I have invested small amounts for 30 years, but I have built up the investments in this portfolio over the past seven years. About £97,000 of this is in an individual savings account (Isa).

"Temperamentally I am probably a value investor, but I’m beginning to see the merits of momentum. I consider selling my holdings in direct shares if they lose more than 10 per cent of their value, and in investment trusts if they lose 5 per cent of their value. I recently sold Templeton Emerging Markets Investment Trust (TEM) and Middlefield Canadian Income (MCT), and some of my holding in Aberdeen New India Investment Trust (ANII) because they had started to go downhill.

"I am also considering selling SSE (SSE) because the company is undergoing a corporate reorganisation. If I do this I will redeploy the proceeds in Lloyds Banking (LLOY) as another income play.

"I want to buy iShares Edge MSCI World Momentum Factor UCITS ETF (IWFM) because it always seems to go up, although doesn’t pay an income. I am also thinking of investing in insurance services provider Randall & Quilter Investment (RQIH) and an infrastructure fund.

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:

I like that you are willing to cut your losses – unlike a lot of investors. It’s often a good idea to sell stocks or funds that have fallen, because falls often lead to further falls. Assets are prone to momentum, especially if they are driven by sentiment, for example emerging markets and mining stocks. Cutting your losses in this way can protect you from savage bear markets. And history suggests that the savings you’ll occasionally make from doing this will outweigh sometimes missing out on bounces.

The same logic suggests it’s a good idea to consider iShares Edge World Momentum Factor UCITS ETF. This is a cheap and easy way to get access to one of the two best-attested stock market anomalies – the tendency for stocks that have recently performed well to carry on doing well. The other stock market anomaly is defensive shares.

Momentum, however, isn’t risk-free. There's always a danger that investors will realise that momentum has driven stocks up too far, with the result that they’ll subsequently do badly. We cannot tell if or when this has happened.

I fear that your investment portfolio won’t deliver the returns you hope for. This is because around a third of it is in assets that have a zero expected real return – cash and gold. So even if the rest of your portfolio does well you should expect to fall short of 5 per cent annual gains after inflation – the prices of safe assets are high that their expected returns are low. In this respect we face a sharp trade-off between risk and return.

James Norrington, specialist writer at Investors Chronicle, says:

You don’t have too many holdings with just 12 investment assets, cash and your home. You have avoided racking up lots of small holdings that are individually too insignificant to make a difference. You have diversified the holdings across different asset classes and have a sizeable cash buffer for emergencies.

Having over 25 per cent of your portfolio, excluding your home, in cash is conservative, especially with interest rates lagging consumer price index (CPI) inflation. But it's sensible to have plenty of cash set aside and, as you want to preserve your capital, at your stage in life the smaller your overall wealth, the greater the proportion of it that should be allocated to cash. For example, if you had £1.2m then the corrosive effect of inflation on £300,000 cash would be akin to burning money. But with £120,000 you should look at the absolute figure rather than percentages - £32,000 in cash is cautious but not excessively so.

Ben Yearsley, director at Shore Financial Planning, says:

Your overall financial position is pretty good. You have no debts, a decent pension income which is partly inflation protected and investments, most of which are sheltered in an Isa. Consider moving the rest into Isas as soon as practicable.

But you want an income of 5 per cent a year and your capital to keep pace with inflation, which would require another 3 per cent. You also would prefer to lose nothing – so want an 8 per cent a year return without taking risk. But you can’t achieve this without taking a reasonable degree of risk.

I’m not sure that now is the time to move into momentum, however the value call is one I do agree with. Momentum has been in vogue for many years but, like any style based investing, will go out of fashion.

I don’t like mechanical stop-losses, which is what you seem to have. The market has fallen 10 per cent from the peak, so have you sold all the direct share holdings that have made a similar loss or greater? And the danger with selling out is how do you know when to buy back in?

HOW TO IMPROVE THE PORTFOLIO

Chris Dillow says:

The riskier parts of your portfolio are indeed risky. Income often comes at the price of cyclical risk, the danger of losing a lot in recessions. And this could well be the case for you. A downturn would see a rise in the risk of defaults, which would hit holdings such as Volta Finance (VTA), CQS New City High Yield Fund (NCYF) and Real Estate Credit Investments (RECI). It would almost certainly also hurt smaller companies, so probably have a detrimental effect on Rights and Issues Investment Trust (RIII).

In this context, your cash and gold have a valuable role as they help to diversify away from this risk. 

Another risk is rising interest rates here and in the US. If these go up it might result in losses for gold, because as cash becomes more attractive there’ll be less demand for assets that don't offer a yield. However, rising interest rates might also be detrimental to equities and high-yield bonds as investors no longer buy higher-yielding assets in their hunt for income, as they have done in recent years. So in this context your cash allocation is wise.

These considerations don’t mean you should immediately reorganise your portfolio. Global equity tracker funds, my default suggestion, are vulnerable to the same risks as your holdings. And the counterpart to nasty losses on cyclical assets in bad times is good returns in normal ones. You should watch the shape of the US yield curve, which is pretty much the only predictor we have of global recessions. If 10-year yields fall below two-year yields, consider getting out of cyclical assets.

James Norrington says:

The investment strategy of the non-cash part of your portfolio is puzzling and doesn’t tally with your stated attitude to risk. This investment portfolio could easily fall by more than 10 per cent in a bear market. You hold investment trusts which are listed vehicles so have market or beta risk, because the value of their shares can get pulled around by their co-movement with the rest of the market. But this shouldn’t matter if you’re investing for income, and you could use such fluctuations to take advantage of any share price discounts to net asset value (NAV) to top up holdings and boost your income.

The value of the underlying assets in the investment trusts you have purchased could be highly volatile, which isn't suitable for your stated risk appetite. Roughly a fifth of your investment portfolio is exposed to emerging Asia and Asia Pacific, which is at odds with your concerns on President Trump’s trade wars. You are also concerned about Brexit risk but your holding in Rights and Issues Investment Trust leaves you exposed to this as it mainly invests in small- and mid-sized UK companies.

But we shouldn’t just evaluate individual holdings. Modern portfolio theory rests on the principle that holding a diverse mix of assets will protect against losses overall, as asset returns are differently correlated. The problem with this is that correlations can change and, for example, during 2008 to 2009 most assets went down together. Your mix of investments may move differently but there is no guarantee. Your portfolio could lose more than 10 per cent in a period of turmoil.

Diversification also means spreading thematic risk and although your portfolio includes different asset classes they could all be adversely affected by similar factors. A global recession would be very bad for your equity holdings and the private equity funds you hold. It would also spark a rerating of the real estate assets that back some of the holdings of your fixed income funds, and the companies that issue the bonds they invest in could be at risk of insolvency. Rising interest rates are also a risk because they can cause the prices of bonds to fall so could mean capital losses for bond funds. 

The investments you have are not compatible with being risk averse but your attitude is certainly loss averse. This may lead to mistakes in how you manage this portfolio, which could surprise you in a downturn. Selling on negative momentum can be the right decision, but always exiting positions when they start to slide isn’t a good long-term strategy. You often end up crystallising losses and missing out on the early stages of recovery upside in a turnaround. If you are worried about big falls it would be better to hold less volatile investments, although if you do this you will have to lower your return expectations.

Looking at your wealth holistically, you own your home, have a secure pension income and keep a quarter of your remaining wealth in cash, so have the capacity to take risk with your investment portfolio. But it may be more circumspect to sacrifice some of the required rate of return.  You could take out some of the credit and duration risk from your fixed income funds and rebalance the equity holdings to include exposure to more established developed markets. This would reduce your reliance on theoretical negative correlations to control portfolio downside risk.

Ben Yearsley says:

Your investment portfolio, which includes direct shareholdings alongside exposure to real estate, India, Europe, Asia and gold, doesn’t match your stated risk profile. I'm also surprised that you still have an India fund in the portfolio, following the recent run.

I would get rid of some of the riskier positions and focus on a few new areas. I’d have a core of equity income and bond funds, plus a few of the direct shareholdings that you already have, such as Legal & General (LGEN). 

The current market malaise provides a decent opportunity to buy into some attractive yields at depressed valuations. Equity income funds are yielding close to 5 per cent and individual equities are yielding around that and in some cases more. Markets are at these levels because many UK domestic stocks have been struggling due to concerns on Brexit, although these concerns are overdone in my view. And more recently the US trade war with China has been the big worry for stocks such as HSBC (HSBA) and Standard Chartered (STAN) in the UK, which have come off heavily, and as emerging markets and Asia have also been hit.  Stocks yield more today than, say, a year ago as the risks are probably that bit higher.

That said, UK domestics and financials look cheap. You are thinking of investing in Lloyds Banking and could also consider other banks for good yields, with the exception of Standard Chartered and Royal Bank of Scotland (RBS). Life insurers Aviva (AV.) and Legal & General, meanwhile, yield over 6 per cent and are on price/earnings ratios of 15.94 and 9.35, respectively. And if you hold these within an Isa you will not pay tax on the dividends.

As well as buying individual equities think about adding some equity income funds. Artemis Income (GB00B2PLJJ36), for example, has a 12-month yield of 4.35 per cent and Standard Life Equity Income Trust (SLET) has one of 4.36 per cent.

In the bond space I would keep TwentyFour Income Fund (TFIF) and add a global total return credit fund. I would also add some exposure to infrastructure, which you are already thinking of investing in, via Foresight Solar Fund (FSFL). This invests in solar generating assets that typically get subsidies and have some inflation linking.

I’d keep Rights and Issues Investment Trust and add Personal Assets Trust (PNL), of which the primary objective is to preserve wealth and grow it in line with inflation. This investment trust almost always holds gold, so you could sell the physical gold you currently have.