Build up cash and cut your number of holdings

“I would like to be able to retire in comfort by the time I am 60,” says Richard. “I have two final-salary pensions, which will pay a total of around £25,000 a year in today’s prices from this age and should cover basic living costs. I have an interest-only mortgage as the debt is reducing in real terms each year, and may use future income or the money from the investment portfolio to pay it off by the time I am 60, depending on our personal circumstances. Otherwise the monies in the investment portfolio will be for luxuries such as holidays as I would like to travel when I retire.

"I plan to start moving some of the investment portfolio into cash when I am in my mid to late 50s so I have an emergency fund, and won’t have to draw from the portfolio when its value has fallen. But otherwise I will take the natural yield each year, and would like the portfolio to have an average yield of 4 per cent to 5 per cent a year that amounts to at least £50,000. But I’m prepared to be flexible on the amount I draw from the portfolio.

"I invest the maximum amount possible into my wife’s and my own individual savings accounts (Isas) every year, so currently £40,000. This is split equally between the 20 funds in them, and I make monthly contributions. I plan to continue investing at that rate until I start drawing down the portfolio.

"I have been investing for six years and am comfortable with risk. I would be prepared for the value of the portfolio to fall 50 per cent in a year, although I wouldn’t like it. In a worst-case scenario, I will carry on working past age 60 to give the portfolio time to recover – I am flexible with my plans.

"I take a long-term view and believe that equities will outperform other assets over 15 years. So I see little point in asset diversification – it might even out annual returns making the ride along the way less bumpy, but could result in a lower total return at the end.

"I was thinking of cutting the number of funds in our investment portfolio to around 10 as managing 20 is a bit of a pain. I am also concerned that active funds' returns are no better than those of tracker funds despite their higher charges. However, I monitor the funds carefully to make sure they’re generally in the top two quartiles of their sectors, and the global spread hopefully means their overall return is better than that of a tracker fund. I'm also not cutting holdings at the moment because of the market correction – I don’t want to sell a fund when it’s fallen heavily and be out of the market if it bounces back up. So I will probably reduce the portfolio to around 10 funds when the correction is over.

"The only fund I’m thinking of adding is Baillie Gifford Shin Nippon (BGS) and, if I did, I would first sell the three Japan funds I currently hold and redeploy the proceeds into that.

"The kids have a Junior Isa each and I hope they will use these funds to pay their university fees or as a deposit for a property purchase. I invest £100 into each Junior Isa a month, and one is worth around £18,000, and the other two are each worth around £12,000.

"I’d like to preserve wealth for my children as an inheritance but it’s not my primary concern. And in any case, if I only take the natural yield from the portfolio the value of the capital should be largely left intact."

Richard and his wife's investment 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:

You think equities will outperform other assets over the long term and that there’s no point in asset diversification for a long-term investor. If the future resembles the past, you are correct.

History suggests that a reasonable expectation for real total returns on global equities is around 5 per cent a year on average. With such a return, and assuming you save £40,000 a year in real terms, your portfolio should grow to over £1.6m. That’ll give you enough to pay off your mortgage and generate an income of £50,000 a year without eroding your capital.

Better still, historic volatility suggests there are only moderate risks to this because there’s only around a one-in-six chance of you falling short of your objectives.

But, such a happy prospect rests upon a very questionable assumption – that the future will resemble the past. It might not. Until recently, history was perfect for investors: in the last century we saw the defeat of worker militancy and revolutionary socialism, the triumph of shareholder-friendly policies, and ongoing growth. But I wouldn’t bet much on the next 20 years being as good for shares as the past 100 have been.

The case for asset diversification for long-term investors is to protect against the unquantifiable danger that the future will be nastier than the past. Luckily, your assets are diversified. Human capital – your ability to earn a living – is an asset as much as financial wealth. For many people this is their biggest asset. The fact you are willing to work past 60, if necessary, is a form of diversification as you are using your human capital to protect yourself against the danger of stock market losses. This insurance makes such an equity-heavy portfolio feasible.

Danny Cox, chartered financial planner at Hargreaves Lansdown, says:

Holding the investments within Isas is important, because this enables you and your wife to switch investments and draw income without incurring tax. However, if you take £320,000 from the Isa portfolios to pay off your mortgage this will reduce the starting income to around £43,000. So paying down the mortgage from income would be sensible.

You should also build up your cash savings. Although your income is significant, in addition to the cash you have for making investments, you should have cash worth three to six months of your expenditure as this would give you more options in an emergency.

Your wife should fund a pension each year. Non-earners can contribute up to £3,600 at a net cost of £2,880. Pension income in your wife’s name will help use up her personal allowance in retirement, which otherwise will go to waste.

Given the amount of tax you pay and your risk profile you could consider venture capital trusts (VCTs), which offer 30 per cent income tax relief subject to certain conditions, and tax-free dividends.

Rory McPherson, head of investment strategy at Psigma Investment Management, says:

You have a good appreciation of the risks and opportunities of equity investing, are a high earner and have decent equity in your home. But you could still benefit from advice on financial planning, and build more resilience and diversification into your portfolio.

You should maybe set a lower level of planned withdrawals in retirement and a lower yield target for your portfolio than the 4-5 per cent you have in mind. With inflation averaging around 2 per cent a more realistic level of sustainable withdrawal would be 3 per cent a year.

You should speak to a certified financial planner to ensure that your investments are structured as tax-efficiently as possible. This would be likely to include a review of your cash allocation and pensions, and an assessment of the merits of making capital repayments on your mortgage and using your wife’s allowances.

It is likely that you would be advised to hold cash worth three to six months of your expenditure. Your current allocation to this asset is very low, which, combined with an investment portfolio totally invested in equities, could cause unnecessary stress on your short-term finances.

Good planning advice would be most relevant with regard to your pensions. It would be helpful to get your two final-salary pensions valued or tested against the lifetime allowance, which is currently £1,030,000. As an additional-rate taxpayer you could reduce your income tax charge by contributing to a personal pension, but there are limits around the size of contributions, which are capped at £10,000 per year for earnings over £210,000.

Depending on how your investments are structured, it may make sense for your wife to hold any investments that are outside Isas, given her basic-rate tax status, or consider a stakeholder pension.

HOW TO IMPROVE THE PORTFOLIO

Chris Dillow says:

I’m not totally happy with your portfolio of actively managed funds. It is well diversified, but diversification dilutes outperformance as well as underperformance. When you hold 20 funds you only have a 0.3 per cent chance that 11 or more will be in the top quartile of their sectors. You also only have a small chance of most being in the bottom quartile too. But diversification results in mediocrity.

This isn’t necessarily a bad thing, but you can achieve mediocrity with a low-cost global tracker fund. Holding lots of funds increases costs and over the long term charges compound horribly. For example, half a percentage point of extra charges on a £300,000 portfolio over 16 years adds up to almost £50,000.

It’s annoying to sell an asset before it rises. But as most funds are correlated with each other, by virtue of being correlated with the global market, consolidating your holdings won’t mean missing out because the funds you switch into should rise too.

Ask yourself, why do I need an actively managed fund rather than a cheap exchange traded fund (ETF) that tracks the market the fund invests in? A fund manager’s track record isn’t good enough evidence – there’s usually a high noise-signal ratio in past performance. Instead, look at whether the manager is backing factors that have a fair chance of outperforming on average over the longer run. Here, my preference is still for quality defensives.

Danny Cox says:

You want to build a portfolio that will provide an income of £50,000 a year from age 60 to add to the £25,000 a year you will be able to draw from defined-benefit pensions. You will also receive the state pension from age 67.

You plan to draw just the natural yield from your investments. This is sensible as it gives the capital, and subsequently the income, the best chance of growing. Doing this also protects your investments against rising price inflation and market falls. Spending capital during poor market conditions can permanently damage the long-term value of a portfolio.

Assuming the average return on the Isa investments is 5 per cent after charges, and both you and your wife continue to invest £20,000 pa year, in 16 years your Isas could be worth around £1.4m. But there is little in the way of yield in the portfolio, so it will need a radical change as you approach age 60 to meet your income needs. If the underlying investments were switched to income-generating ones, a 4 per cent yield would provide £56,000 a year.

The FTSE All-Share index typically yields between 3.5 per cent and 4 per cent. This is a pretty good yield expectation for an Isa portfolio intended to generate rising income and growing capital. Getting a higher yield than this either requires exposure to alternative asset classes such as corporate bonds or equity holdings that have seen considerable market falls. Overseas diversification is likely to reduce rather than increase the yield. But a higher yield naturally reduces growth potential, which can have an impact on income later in retirement as inflation bites.

The Isas have relatively little exposure to the UK, so have benefited from the weakening pound and loss of confidence in the UK economy. This could, of course, turn against them.

You are right to consider consolidation as 10 is a better number of funds than what you currently have.

Rory McPherson says:

Your investments are only in equities with significant exposure to Japan, smaller companies and emerging markets. This is clearly where the value is and I sympathise with not wanting to trade reactively in extremely choppy down markets.

But as markets stabilise, I’d look to add more ballast and diversification to your portfolio. Funds such as the TwentyFour Dynamic Bond (GB00B5VRV677) and TwentyFour Corporate Bond (IE00BSMTGG87) would fulfil this role, and are also a source of potential capital growth and income. TwentyFour Dynamic Bond Fund has a yield of around 4.6 per cent, and they both are benefiting from a 'Brexit premium' because UK financial bonds are trading at much wider marks than their international counterparts.

Also consider more income-focused areas of the equity markets via funds such as Legg Mason IF RARE Global Infrastructure Income (GB00BZ01WV25), which has a yield of over 5 per cent. And think about some exposure to more cash-generative and defensive parts of the equity market.