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Cut your equity exposure and number of holdings

Not only will this reduce your risk, it will also make the portfolio easier to manage in a volatile market
February 21, 2019, Paul Derrien and Richard Hunter

John and his wife are age 64, and she has retired. John still works part-time as a consultant, which earns him £30,000 a year. They will start to receive state pensions from the end of this year, which will amount to £15,000 a year in total. All their other pensions have been consolidated into self-invested personal pensions (Sipps). John has taken his 25 per cent tax-free entitlement to settle a tax bill, but otherwise they have not drawn on the Sipps and don’t intend to.

Reader Portfolio
John and his wife 64
Description

Sipps, Isas and trading accounts invested in direct shareholdings and funds, cash, residential property

Objectives

3.5% a year total return, pass on assets to children tax efficiently

Portfolio type
Investing for goals

They have two sons who have jobs, but to whom they have given money to help with property purchases. These gifts were largely made more than seven years ago so should not incur inheritance tax.

John and his wife plan to pass their assets to their children via capital preservation trusts. So, for example, their home, which is worth about £1m, is owned by an asset protection trust.

“Almost half our investment portfolio is in Sipps and individual savings accounts (Isas),” says John. “I reckon we should be able to live off the income from this if it yields 3.5 per cent, which seems possible. This should cover routine outgoings, so I think of any income from outside the investment portfolio and our state pensions as a little bonus. We also own a holiday home abroad worth £450,000, which normally makes a net income of about £9,000 a year. If we used it less it could produce an income of £16,000 to £20,000 a year.

"I don’t budget. As long as the value of our investments including cash doesn’t drop below a specified level, we will spend less than our income and not draw on capital. We have no debt, and feel well off when markets are high and don’t worry too much when they drift down. 

"We would like our investment portfolio to make a total return of 3.5 per cent a year until inflation rises, at which point we would like 2.5 per cent more than what is a positive real return.

"Our investment portfolio was mainly built up over the past seven years with the proceeds of the sale of my accountancy practice. But in the past two years we have sold assets worth £400,000 to pay a tax bill and the value of our investments has fallen in the past few months.

"We have a sizeable cash allocation because we recently sold a property, but don't feel like reinvesting the proceeds. We are nervous because of the Brexit situation, the possibility that Labour will win the next election and US president Donald Trump. We won’t invest much in the next year or two unless there is a big stock market downturn in which the FTSE 100 index falls below 5800.

"We will hold cash worth two years of our expenditure unless we see some very good investment opportunities, at which point we will reduce it to one year's or 18 months' worth. We want to have a cash buffer so that we are not forced to sell investments when the market is low.

"I have been investing for seven years, and as I am a chartered accountant try not to speculate when selecting investments. I usually spend less than half an hour a month making adjustments to the investments, although do spend a few hours a month reading investment information. And every two or three months I spend four or five hours on the portfolio, including speaking to our broker and following up on his comments.

"I would be prepared for the value of our investments to fall 15 to 20 per cent in any given year. I avoid investments whose value I think will go down for long periods when interest rates go up, and I don’t think fixed-interest investments are safe. But I do hold some ‘bond proxies’ – shares with safe, predictable returns and relatively high yields. 

"I don't try to make gains over periods of under two years, as by selling too early I missed out on massive gains with investments in shares including Evraz (EVR) and Kaz Minerals (KAZ). Instead I look for quality yield, long term growth potential or both.

"We also own stocks such as Amazon.com (AMZN:NSQ), Alphabet (GOOGL:NSQ) and Tencent (700:HKG), but will take profits on these when they ‘hit a ceiling’. We have done this to a certain extent with Amazon and 3i (III). We have also recently sold shares in Johnson & Johnson (JNJ:NYQ) worth $58,000 (£44,880.40).

"We have recently invested $31,000 in Thermo Fisher Scientific (TMO:NYQ) and $26,000 in American Water Works (AWK:NYQ).

"When we next invest we will probably increase our allocation to US infrastructure and healthcare companies, and maybe reinvest in companies we used to hold, including AstraZeneca (AZN) and GlaxoSmithKline (GSK)."

 

John and his wife's portfolio

Holding Value (£) % of the portfolio 
3i (III)63,9931.9 
3i Infrastructure (3IN)29,5140.88 
Alibaba (BABA:NYQ)35,9261.07 
Alphabet (GOOGL:NSQ)66,0361.96 
Amazon.com (AMZN:NSQ)65,5101.94 
American Water Works (AWK:NYQ)18,2890.54 
Anglesey Mining (AYM)1980.01 
Apax Global Alpha (APAX)54,8441.63 
Aurelius (AR4:BER)17,5400.52 
Aviva (AV.)19,2130.57 
BAE Systems (BA.)36,0621.07 
Barclays (BARC)9,9110.29 
BASF (BAS:BER)18,7400.56 
BHP (BHP)21,2670.63 
BP (BP.)36,6311.09 
Citigroup (C:NYQ)22,2380.66 
Delta Air Lines (DAL:NYQ)19,3140.57 
Diageo (DGE)22,7050.67 
Direct Line Insurance (DLG)14,2800.42 
Empiric Student Property (ESP)25,7140.76 
Facebook (FB:NSQ)10,7600.32 
General Electric (GE:NYQ)8,0980.24 
Goldman Sachs (GS:NYQ)11,5540.34 
HeidelbergCement (HEI:BER)13,2130.39 
HICL Infrastructure Company (HICL)33,2820.99 
Hostelworld (HSW)16,8770.5 
HSBC (HSBA)32,7190.97 
IMI (IMI)10,1900.3 
International Public Partnerships (INPP)27,7900.82 
Interserve (IRV)1,2210.04 
JD.Com (JD:NSQ)12,7740.38 
John Laing Environmental Assets Group (JLEN)19,9980.59 
John Laing (JLG)40,8281.21 
Johnson Matthey (JMAT)19,1520.57 
JPMorgan Chase & Co (JPM:NYQ)14,2310.42 
JPMorgan Global Emerging Markets Income Trust (JEMI)22,5010.67 
Legal & General (LGEN)43,0501.28 
Lloyds Banking (LLOY)27,2500.81 
Lockheed Martin (LMT:NYQ)39,6051.17 
Macquarie Infrastructure (MIC:NYQ)23,5480.7 
Marston's (MARS)13,8190.41 
Melrose Industries (MRO)24,7110.73 
Microsoft (MSFT:NSQ)51,1961.52 
National Grid (NG.)41,1411.22 
Noble Energy (NBL:NYQ)9,1500.27 
Novo Nordisk (NOVO B:CPH)22,3200.66 
Polar Capital (POLR)23,4730.7 
PRS REIT (PRSR)43,0531.28 
Prudential (PRU)24,8220.74 
Rio Tinto (RIO)36,4711.08 
Rockhopper Exploration (RKH)4360.01 
Royal Dutch Shell (RDSB)32,2020.96 
Severn Trent (SVT)23,7790.71 
Smith & Nephew (SN.)26,5070.79 
Spotify Technology (SPOT:NYQ)7,7850.23 
Standard Life Aberdeen (SLA)20,4210.61 
Tencent (700:HKG)28,1470.83 
Tesla (TSLA:NSQ)11,2010.33 
Renewables Infrastructure Group (TRIG)16,2130.48 
Thermo Fisher Scientific (TMO:NYQ)24,7200.73 
Tripadvisor (TRIP:NSQ)9,8170.29 
Tullow Oil (TLW)6,3790.19 
Unilever (ULVR)16,8620.5 
United Utilities (UU.)29,9060.89 
Utilico Emerging Markets Trust (UEM)28,6840.85 
Vodafone (VOD)16,4900.49 
Weir (WEIR)15,7300.47 
Xylem (XYL:NYQ)26,0990.77 
UK residential property1,000,00029.66 
Overseas residential property450,00013.35 
Cash2634697.81 
Total3,371,569  

 

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:

I sympathise with your antipathy towards bonds. They offer some insurance when equity prices fall as a result of increased risk aversion or fears of a recession. But this insurance is expensive, and might not be necessary.

This, however, leaves you with the problem of how to protect yourself against equity risk. I suspect that such protection won’t be necessary this year, as equities are sufficiently underpriced to more than compensate for their risks.

But I don't think there is a strong enough basis for a massive exposure to equities. If we take reasonable long-term expectations for equity returns – a 5 per cent real total return with a standard deviation of 15 per cent – there’s a roughly one in six chance of you losing 10 per cent in a year, and roughly a 5 per cent chance of you losing 20 per cent. As you don't hold bonds, and are partially retired so don't get much labour income, you lack two of the most common ways of diversifying these risks. It’s in this context that your cash holdings are a good idea.

But waiting for buying opportunities is not a good reason to hold cash. The best such opportunities come when stocks are bombed out because investors are very scared. In such scenarios, however, you too might lack the courage to buy. Instead, your cash holding is a sensible medium-term asset allocation decision.

 

Richard Hunter, head of markets at interactive investor, says:

You have assets other than your investment portfolio which reduce your reliance on it, and ensure you have an emergency cash fund, adequate pension provision and a way to cover your routine expenditure.

You could stomach a 15 per cent to 20 per cent loss in your investment portfolio in any one year. But you could mitigate this with a stop-loss order on your stocks, whereby holdings would be sold if they fall by a pre-determined amount of your choosing, for example 5 per cent or 10 per cent.

 

HOW TO IMPROVE THE PORTFOLIO

Chris Dillow says:

This portfolio seems overdiversified. By holding more than 60 shares you are largely diversifying away the risk of individual stocks and instead exposing yourself to market risk. This means you end up with something like a tracker fund, but with higher dealing costs and the greater hassle of monitoring each holding.

However, my concern is mitigated because you seem to be taking on the right sort of stock exposures. You are overweight big defensive stocks that have what Warren Buffett calls 'economic moats' – sources of monopoly power such as high capital requirements or strong brands. Examples of such stocks in your portfolio include Microsoft (MSFT:NSQ), Amazon, Unilever (ULVR), Diageo (DGE) and oil majors. Historically, this factor has paid off well.

However, there is a danger that investors have wised up to the historic underpricing of moats so have driven up the prices of such shares too much. And if this is the case their future performance could be poor. Unfortunately it’s almost impossible to quantify this risk.

You are also exposed to some cyclical risk via your resources and emerging market holdings. With investors now worrying about a slowdown in China, this risk could pay off well – if and when we get signs of a Chinese recovery. But so far there are few signs. So you might be holding them too early.

Your portfolio is exposed to political risk, as Severn Trent (SVT), United Utilities (UU.) and National Grid (NG.) might be nationalised by a future Labour government or face tougher regulation. Their high yields reflect this danger and the risk you are taking could pay off well if we don’t get a Labour government. But if we do, these companies' share prices could be negatively impacted. 

 

Paul Derrien, investment director at Canaccord Genuity Wealth Management, says:

You are getting the income you need from your portfolio, and any reduction in it could be made up from your pensions, more rent from your investment property and some additional consultancy work. This is a very good start.

Your portfolio also looks well diversified. It has a good mix of global equities and none of the holdings is excessively large.

But the performance of the investments over the past seven years, during which you have been actively managing and building the portfolio, should have been good and this could lull you into a false sense of security. The portfolio composition is also at odds with your attitude to risk.

Given your understandable caution about the direction of markets, your overreliance on the portfolio for income worries me a little. I would suggest some closer analysis of asset performance during the noughties even though that was an extreme time. If you are only willing to accept downside risk of 15 per cent, limit the downside risk by greatly reducing your equity exposure and balancing your portfolio with alternative assets. Based on your stated aims, I would suggest an investment portfolio with an allocation to equities no greater than 60 per cent.

Alternative assets don’t have to be fixed income. But there are shorter-dated UK corporate bonds that will provide similar yields to the portfolio in its current form. And there are UK government and corporate index-linked bonds, such as Severn Trent Utilities Finance 6.125% GTD BDS 2024 (83NL) and National Grid Sterling RPI Linked Bonds 06/10/2021 (NG1Q), which provide returns well above retail price index (RPI) inflation. If you held these alongside your existing holdings in infrastructure, real estate investment trusts and cash, you would create a portfolio with significantly lower risk.

Although the number of holdings provides diversification, there are too many to actively follow in enough detail. Some of the holdings are very small, so if you adopt the approach I have suggested, sell those ones. Even if you don’t take this approach I would still rationalise your portfolio so that you only hold the equities you have most conviction in. There is no set number to aim for, but I am more comfortable with at most 20 direct shareholdings, alongside collective funds, such as exchange traded funds (ETFs) and investment trusts, to provide the overall diversification you are looking for.

We often feel we can reduce our equity exposure in a falling market, but the psychology of this makes it much harder in practice. Investing via ETFs removes much of the emotion and makes it easier to take, say, 5 per cent to 10 per cent out of a portfolio, in contrast to trying to decide which companies to sell. This would really help your risk management strategy.

You seem to have a strategy for taking profits, but not for cutting losses. There are several holdings sitting at large losses in your portfolio. Hanging on to a falling stock should be avoided, as should doubling down – too many investors do this due to emotion rather than common sense. If a stock falls between 15 per cent and 20 per cent, cut it and move on unless there are exceptional reasons not to.

 

Richard Hunter says:

For the most part, you have constructed a well-balanced and diversified portfolio, which needs relatively little attention given your investment objectives. Due to the variety of markets and businesses in which the companies you hold operate, you have diversification in terms of business mix and exposure to foreign markets. For example, Prudential (PRU) operates in Asia and the US, as well as the UK.

And there are a number of stocks that should add a defensive element to the portfolio during difficult market conditions – something of particular relevance at the moment.

But having around 70 investments is unwieldy, particularly if you spend a relatively small amount of time each month ensuring the holdings still meet your objectives. You have to be comfortable with this selection of stocks if you continue to hold them, but determining whether this is the case will be a large task given the number of them.

If you reduce the number of your holdings, I would suggest disposing of ones less than around £10,000 in size. Alternatively, you could take a hard look at some of the underperforming stocks and, if they no longer meet your requirements, sell them.

You want a yield of 3.5 per cent a year, but at time of writing the investment portfolio's average dividend yield is 3.4 per cent. This is partly due to your numerous holdings in US stocks, blue-chips that typically yield less than their UK counterparts. The average yield of the FTSE 100 at the time of writing is 4.5 per cent.

To increase your investment portfolio's overall average yield, you could reduce your allocation to US stocks rather than looking to increase it. 

Or review your UK stocks: 21 of these are FTSE 100 companies, but only three of them are among the top 10 yielding companies in this index – Standard Life Aberdeen (SLA), Vodafone (VOD) and Direct Line Insurance (DLG). You don't have, for example, Barratt Developments (BDEV), Imperial Brands (IMB) and Centrica (CNA). But you would need to do additional research to see whether such UK stocks meet your overall objectives, as dividend yield alone is not a reason to hold a stock.