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De-risk and diversify your portfolio

Having many holdings doesn't necessarily achieve diversification
March 7, 2019, James Norrington and Jason Porter

Jasper is 54 and his wife is 52. They live in Uganda and have four children between the ages of 10 and 20, some of whom are at university in the UK. Jasper and his wife met and married in the UK, but now expect to stay in Uganda or another part of Africa.

Reader Portfolio
Jasper 54
Description

Direct shareholdings, residential property, funds, cash

Objectives

Pay children's education fees, emergency fund, cover extra expenses and luxuries, fund for children's life costs

Portfolio type
Investing for children

Jasper’s salary and rental income generate about £95,000 a year and this should cover their basic expenditure, travel and holidays. In addition to this Jasper’s wife earns a salary as a dentist.

Their home is worth about £195,846, and they have a buy-to-let property in South Africa valued at about £451,953, which gives them a gross monthly rental income of £1,505.

“I have a few small pension plans from previous employers across Africa that I have not continued to pay into because of erosion in local currency values,” says Jasper. “I prefer to put money into US dollars as often as I can – when I have spare cash or lump sum payouts such as bonuses from work. We own our home and view our properties as my pension – I will sell them if necessary and buy an annuity with the proceeds.

"My wife has a workplace pension that she thinks will be enough to augment her savings and live on without any support from me, if necessary, when she retires in six or seven years.

"Our investment portfolio is mainly to help pay our kids' overseas education fees and related expenses of approximately £75,000 a year. We will also use it to support any health or other overseas emergencies, and the occasional extra holiday and luxuries. My ‘back of the envelope’ calculations suggest that we will need approximately $120,000 (£90,363.60) a year for many years, primarily for education fees. For example, as non-UK residents we currently pay university tuition fees of around £33,886 a year for our eldest son.

"I also want the portfolio to be a source of funds for the children’s life expenses in the future and to get them into the habit of investing. So I plan to put the investments into a trust structure for them.

"We are also looking at whether our children at university in the UK could hold investments in tax-efficient wrappers such as individual savings accounts (Isas) and self-invested personal pensions (Sipps), as we all have UK passports and they should continue to live abroad for the foreseeable future.

"I have been investing for 33 years, over which time my attitude to risk has become less aggressive, and is now what I would describe as moderate. I could tolerate a loss in my investment portfolio of 10 per cent to 15 per cent in any given year, and maybe more if that loss is due to macro events beyond my control, as I have a longer term growth objective.

"I used to have the time to challenge myself to seek 'hidden value' using knowledge gained through my travels, reading and life experience. I tried to balance growth with income and value., and saw myself as contrarian. And I preferred to invest in direct shareholdings on different stock markets rather than funds because their charges eat into returns. My research led me to well-run companies across the world and I thought I was a good stockpicker.

"But I have ended up with many holdings, so am attempting to gradually cut the number. I have recently sold holdings with a value of less than $5,000 (£3,761.50), which would have had little impact on the investment portfolio’s overall returns, and reinvested the proceeds in better earning stocks.

"I am aiming for a total return of 7 per cent to 8 per cent over the long run, with a decent income of 3 per cent to 4 per cent. I want to earn without sacrificing growth. I realise that I may have to add a few funds to balance the portfolio, and the fixed-income assets I have introduced is a step in that direction. But I don't plan to increase my cash allocation in the short term.

"I also want to add a few funds such as Scottish Mortgage Investment Trust (SMT) because I do not have much exposure to technology companies. And I want to add some ‘dividend aristocrats' – S&P 500 shares that have increased their dividends every year for 25 years or more – such as Boeing (BA:NYQ) and Walt Disney (DIS:NYQ). This is to further tilt the balance of the portfolio towards income and long-term stability. I will do this when I have decided which stocks I will sell to fund these investments. 

"But as platform and broker charges discourage me from trading often I only intend to make minor adjustments each year."

 

Jasper's portfolio

HoldingValue (£)% of the portfolio
Zurich Insurance (ZURVY:QXI)48201.551.71
Zoetis (ZTS:NYQ)33230.151.18
Weir (WEIR)13990.000.5
Volkswagen (VOW3:GER)19429.570.69
Vodafone (VOD)11550.310.41
Vivendi (VIVHY:PKC)19304.910.69
Visa (V:NYQ)107624.793.83
Verizon Communications (VZ:NYQ)36423.481.3
Veoneer (VNE:NYQ)8359.850.3
WFD Unibail Rodamco (URW:AEX)19068.020.68
Umicore (UMI:BRU)32735.231.16
TwentyFour Income Fund (TFIF)16987.500.6
Trinity Industries (TRN:NYQ)17900.630.64
Tesco Personal Finance 5% NTS 21/11/2020 (TSC5)25768.750.92
STMicroelectronics (0L9Y)32842.251.17
Standard Bank (SGBLY:PKC)21565.710.77
Spectris (SXS)24470.000.87
Smiths (SMIN)28550.001.02
Schneider Electric (SU:PAR)25977.500.92
Sanofi (SNY:NSQ)16550.430.59
Royal Dutch Shell (RDSA)60780.382.16
Renishaw (RSW)41870.001.49
Relx (REL)32710.001.16
Prudential (PRU)29315.001.04
Primary Health Properties 5.375% BDS 23/07/19 (PHP1)25418.750.9
Pernod Ricard (PDRDY:PKC)24747.280.88
Pennon (PNN)17280.120.61
Novartis (NVS:NYQ)24100.380.86
National Grid (NG.)50921.841.81
Mueller Industries (MLI:NYQ)27963.720.99
Mueller Industries 6% DEB 01/03/2027 (MLI27)20405.920.73
MTN (MTNOY:PKC)19622.290.7
Morgan Stanley Emerging Markets Domestic Fund (EDD:NYQ)25703.310.91
Micro Focus International (MCRO)46147.691.64
Merlin Entertainments (MERL)9301.810.33
Meggitt (MGGT)16941.770.6
Eli Lilly and Co (LLY:NYQ)36702.451.31
iShares MSCI Germany Small-Cap ETF (EWGS:BTQ:USD)39632.941.41
Insperity (NSP:NYQ)37403.031.33
HSBC (HSBA)20712.000.74
Hill & Smith (HILS)35415.001.26
Halma (HLMA)38634.001.37
GlaxoSmithKline (GSK)44433.001.58
Garmin (GRMN:NSQ)25961.920.92
Fortive (0IRE)18518.920.66
Eurofins Scientific (ERF:PAR)35372.251.26
DowDuPont (DWDP:NYQ)19398.560.69
Diageo (DGE)54335.001.93
Deutsche Boerse (DB1:BER)38939.471.38
Deere & Co (DE:NYQ)30767.571.09
Dechra Pharmaceuticals (DPH)24030.000.85
Danaher (0R2B)28280.311.01
Cummins (CMI:NYQ)16327.090.58
CRH (CRH:NYQ)22012.380.78
Cranswick (CWK)58063.802.07
Compass (CPG)22517.390.8
Coloplast (COLO B:CPH)28412.231.01
Cochlear (COH:ASX)28738.221.02
Close Brothers (CBG)31270.001.11
Chesnara (CSN)12040.000.43
Charles Taylor (CTR)20741.820.74
Brookfield Infrastructure Partners (BIP:NYQ)26863.880.96
BP (BP.)17128.570.61
BHP (BHP)31942.001.14
Bayerische Motoren Werke (BMW:BER)32012.141.14
BAE Systems (BA.)30246.001.08
Aviva (AV.)18288.820.65
Autoliv (ALV:NYQ)21442.680.76
AstraZeneca (AZN)82177.502.92
Arcosa (ACA:NYQ)8179.770.29
Amadeus IT (AMADY:PKC)36027.351.28
Air Partner (AIR)22650.000.81
AbbVie (ABBV:NYQ)33500.511.19
Residential property - Uganda195846.306.97
Residential property - South Africa451953.0016.07
Cash934.410.03
Total2811613.17 

 

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 say that you could cope with larger losses if they are “due to macro events beyond my control”. I suspect you speak for many investors, who are hurt by losses both because of the fall in the value of their wealth and the blow to their egos – the realisation that they aren’t as clever as they thought or the regret at having made bad decisions.

For people like you, tracker funds are especially attractive because they take personal judgment out of the game. The losses these make are due to events beyond your control or you having taken on too much risk. You can avoid the latter by holding enough cash and bonds to mitigate losses. If you do this, losses will be due to events beyond your control.

 

James Norrington, specialist writer at Investors Chronicle, says:

Finding out whether there is a tax-efficient trust structure that might suit your needs and if your children are eligible for UK tax wrappers are an important part of planning your family wealth strategy. Consult qualified experts in this area to get the best answers and tax advice.

Overall, you seem to have been very sensible with financial matters over the course of your life. It is good that you own your home and have a separate property income, and recognise the value of having plenty of cash in US dollars for emergencies.

 

Jason Porter, director of specialist expatriate advisory firm Blevins Franks, says:

De-risking your portfolio as you get older to meet different goals and challenges is a normal and important part of financial planning. As part of this exercise, it may make sense to adopt a different attitude to risk. De-risking typically involves moving a portion of your equity holdings into fixed income. Adding more fixed income exposure could also help you meet your goal of an increased yield from the portfolio.

Your stated moderate attitude is not in line with the composition of your investment portfolio. A typical moderate investment portfolio would have a considerably higher allocation to fixed income and possibly other alternative types of assets such as property. We would consider an investment portfolio that has an allocation of around 95 per cent to equities to be aggressive, and the volatility of your portfolio has exceeded the volatility of the most aggressive portfolios we offer clients. The mismatch between your perceived attitude to risk and actual risk of your investment portfolio suggests that it may be worth re-examining the level of risk you would like to take.

This portfolio could benefit from further diversification and an assessment of whether its risk level is appropriate.

 

HOW TO IMPROVE THE PORTFOLIO

Chris Dillow says:

You are right to want to cut the number of your holdings. At more than 70, the average holding accounts for only 1.4 per cent of your investment portfolio. This means that if one holding were to rise 50 per cent this year, which would be a fantastic return, it would add only 0.7 percentage points to your annual return. That’s only the difference between a slightly good day and slightly bad day for the global market. Such huge diversification makes stockpicking redundant. It just adds to the time and effort you need to spend monitoring your portfolio, and the dealing costs of acquiring so many stocks.

Having a large number of holdings doesn’t mean that your portfolio is well diversified. Your portfolio largely comprises big companies with dominant market positions, such as oil majors and large pharmaceutical companies. Historically, this has been the right thing to do, but now it incurs some dangers.

Investors might have wised up to the historic underpricing of companies with what highly regarded US investor Warren Buffett calls “economic moats” – sources of monopoly power such as brand names or big capital requirements. If so, these might now be fully priced.

Another danger is that incumbent firms could find themselves on the wrong side of creative destruction: in future, new technologies might undermine their dominant position. This isn’t a problem in the short run, but it might be over the next 20 or 30 years.  

There are simple ways to spread these risks. You could instead hold a global tracker fund. This backs the field rather than particular horses. You should think of these as cheap funds of funds.

Another way to diversify your portfolio could be to add private equity or smaller companies funds [see last week's big theme for more on this]. These might help to protect the portfolio from the possibility that more future growth will come from companies that are not currently listed on stock markets.

It is difficult to sell existing holdings due to what behavioural economists call an endowment effect – we tend to value things more highly than we should because we own them. And there’s also the fear of missing out – if we sell a stock and it goes up, we kick ourselves. But we don't do this when a stock we haven't invested in goes up.

To overcome these barriers, sell maybe your 20 smallest holdings and buy a global equity tracker fund. A few of the stocks you’ve sold may outperform the tracker, so you will kick yourself for selling them. But equally, a few may underperform. When you feel like reproaching yourself for selling the risers, just remember that you wouldn’t have sold them unless you had also sold the fallers. Net, the relief should largely offset the regret and might even outweigh it.

 

James Norrington says:

The trade-off between the risk and reward of your investment portfolio is very important. If you don't need to draw capital from your portfolio you can avoid crystallising losses. But remember that the value of your portfolio could fall considerably more than 10-15 per cent in a very bad period for global equities.

So consider your investment objectives. In view of the ages of your children and your objective of funding their education overseas, the investment portfolio seems too skewed towards risk assets. Your three eldest children are going to be relying on your support for university fees over the next five years. So a big equity market sell-off like in 2000-03 or 2007-09 could be very detrimental to your portfolio's value as you are drawing capital from it rather than leaving it untouched.

Consider rebalancing the portfolio and adding assets that are likely to perform differently to equities in a stock market sell-off. In the past this would have meant splitting your portfolio between equities and bonds. But years of exceptional monetary policy since the financial crisis of 2007-09 mean that the negative correlations between equity and bond returns may have broken down, and the higher yielding fixed-income instruments in your portfolio might not diversify risk. Bond funds with a higher yield are likely to hold more debt from lower-quality issuers that could suffer badly in a recession, in a similar way to shares.

To de-risk your investment portfolio, consider adding high-quality government debt with a short maturity. Some exposure to US Treasuries – government bonds – might make sense. Thanks to the Federal Reserve’s rate hikes in 2018 sovereign debt offers a decent yield relative to other safer issuers. This also means there is scope for the price of Treasuries to rise if there is a flight to quality in a stock market sell-off. This dynamic might protect the portfolio to a certain degree if equity markets fall, although we can no longer expect government bond price rises to fully compensate for periods of poor equity returns, as they have in the past few decades.

Your direct equity holdings are a blend of quality companies for long-term growth and a few value plays. Good value companies have less far to fall in any sell-off, and better quality firms with robust business models and reliable cash flows are likely to be punished less in such an event.

But at this point in the economic cycle you should reappraise the financial strength of the companies you invest in. Key considerations include their levels of debt, operational gearing and free cash flow, and management of working capital. Also see what off-balance-sheet liabilities they have, such as pension deficits. This type of assessment can help you spot bogus quality and value traps, which may not do so well in the next downturn.

Holding robust companies as part of a more balanced asset allocation will give you the best chance of achieving the portfolio’s short-term objectives and later on supporting your retirement.

 

Jason Porter says:

Your investment portfolio has a very large number of holdings, more than many professionally run global equity funds. It takes a considerable amount of time to monitor each company and make the necessary changes to a portfolio of this size. We suggest placing a portion of the investment portfolio with a professional wealth manager, especially if you are looking to de-risk it and move more money into fixed income.

The global fixed income market is significantly larger and more complex than the global equity market, and a professional manager could add value in this area. Investing in funds rather than direct equities would also decrease the amount of time you need to spend monitoring the holdings. 

Although your investment portfolio in its current form is likely to have achieved excellent returns over the past few years, it is important to remember that equity markets, particularly in the US, have benefited from an extraordinarily long bull market. But this is not guaranteed to be the case going forward so your portfolio could benefit from being better balanced.

The equity portion of your investment portfolio has a significant UK and European bias. Almost 75 per cent of it is invested in the UK and Europe, but these regions only make up around 20 per cent of global equity markets. This leaves the portfolio underweight US, Japanese and emerging Asian markets, and overexposed to regional geopolitical risks such as Brexit. The US has been a key driver of market returns over the past few years, so the underweight position could detract from the long-term growth potential and efficiency of the portfolio. Balancing the regional weightings within the portfolio would help to mitigate country-specific geopolitical risks and incorporate several different regional growth drivers into the portfolio.