How can I improve my diversification?

"My main objectives are to save money, make my investments work as hard as possible and supplement my pension income in retirement,” says John. “We would like to retire early, but don't want to compromise our lifestyle too much. I've calculated that we will need approximately £42,000 a year after tax.

"I left my last job in 2011, since when I have not paid into a pension. I don't have a recent assessment of my former workplace pension – a final-salary scheme. When I last looked at this in 2010 I was told it would pay out approximately £33,000 a year. I accrued 25 years, and my final pensionable salary was £80,000 a year when I left that job and pension scheme. This pension will start to pay out on my 65th birthday.

"I could take this pension earlier, but for each year that I take it before my 65th birthday, I would lose 5 per cent of its value. I want this pension to pay out in full, so I won't draw it until I’m 65.

"I will start receiving my state pension from the age of 67 and my wife will receive an overseas pension from age 65 of about €1,000 (£898.76) a month.

"Since leaving my last job and going freelance, I have tried to use my full annual individual savings account (Isa) allowance as an alternative to a pension. But I started investing before this via an employee share scheme, buying small quantities of shares over many years at significant discounts. 

"When I inherited some money in 2012 I started to invest in other direct shareholdings. I aim to be a long-term owner of well-managed companies and only sell holdings if my original reasons for investing in them no longer stand. I also take a buy-and-hold approach because I have limited free time. But I try to keep up to date with financial news on a weekly basis, and I review my investments four times a year.

"I have recently inherited a cash sum worth of £300,000 and wondered how to invest it. I thought of investing some of it by drip feeding £40,000 a year into my and my wife’s Isas over the next four years.

"I try to diversify holdings across different companies, industries and geographies. I focus on total returns, so invest in both growth and income shares. However, I am leaning towards dividend-paying companies because this seems to instil some discipline and these companies have tended to perform better. Dividend income also mitigates the risk of a company’s share price not increasing and you can reinvest dividends.

"I aim to have between 20 and 30 direct shareholdings. I would like each shareholding to account for 5 per cent of my investments. But some of my smaller holdings, such as ITV (ITV), have lost value, while some, such as Halma (HLMA), are now overvalued limiting reinvestment opportunities.

"I am struggling to find quality long-term shares at a fair price – they seem mostly overvalued. I would like to invest in foreign shares, and have long been interested in companies such as L'Oreal (Fr:OR), Adidas (Bud:ADIDAS), BMW (Ger:BMWX) and Microsoft (US:MSFT). But I am worried that withholding taxes would reduce the overall gain and don't want the extra administration. I am also not sure if they can be held in Isas.

"I am heavily exposed to equities because bonds have not offered a good return over the past few years. I have cash in my limited company worth £106,000 that would cover about two years’ living expenses, in case I cannot get work. I have savings worth £80,000 to cover property maintenance and enhancements over the next three to five years, after which annual maintenance costs on our house should be minimal. And I have cash in a savings account worth about £50,000.

"But I wondered how else I could improve the diversification of our investments? I have not been tempted to invest in active funds because I think that they have high fees, and there is a lack of transparency on their underlying holdings and charges. I also think that investing in direct shareholdings is more interesting."

John 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 THESE INVESTORS' CIRCUMSTANCES.

THE BIG PICTURE

Chris Dillow, Investors Chronicle's economist, says:

I like that you avoid active funds, try not to trade much and keep your holdings to between 20 and 30 stocks so avoid overdiversification.

However, your portfolio has a bias to stocks with what high-profile US investor Warren Buffett calls economic moats – sources of monopoly power that help protect a company’s profits from competition. These moats can be big brands such as Unilever (ULVR), Diageo (DGE) and Carnival (CCL) have, or high capital requirements as is the case with Royal Dutch Shell (RDSB). Historically, such a strategy has paid off well because investors have under-rated the importance of moats, causing stocks that have them to deliver better than expected profits.

But investors might now have wised up – probably a reason why such stocks have risen so much in recent years. This raises the risk that their future returns will be poor or even negative because they are no longer underpriced. This is a reason why you should consider trimming, for example, Unilever, although the fact that it accounts for a large portion of your portfolio is not in itself a problem.

I dispute your assertion that a big dividend mitigates the risk of a company’s share price not increasing. This is not guaranteed at all and, on the contrary, a high dividend can warn of high risk. Many stocks have offered high yields shortly before collapsing, notable examples being Northern Rock and Carillion.

A particular danger here is cyclical risk. In a serious downturn, construction stocks such as Redrow (RDW), aviation stocks and banks would be hit hard. Their decent yields are partly a reward for this risk. The best predictor of whether such a risk will materialise is the shape of yield curves: if long-dated yields are below short-dated ones, it’s a sign of recession. With the US yield curve inverted and the UK curve having flattened, this risk is now higher than usual, although a recession is not imminent.

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

You are in a very favourable position. Your cash flow is extremely positive, and you have substantial and balanced savings. Your investment strategy is mostly spot on and you are in a position to reduce how much you work and supplement your income from your investments, if necessary. Or you could use this surplus to increase your portfolio. After age 65 your income levels should almost match your expected needs, so the income from your investments could be mostly supplementary.

The next few years are the most critical for you and your wife as you wind down into retirement, because it is very important at this point to organise your investments in a more balanced way. I would treat your equity-focused investments and a large proportion of your cash as a single pot. Based on your circumstances, it would be sensible to have 60 per cent of this combined investment pot in equities and 40 per cent in other assets, without taking excessive risk. So you have excess cash that needs to be put to work to keep pace with inflation. 

Assets that are not in Isas could be held in your wife’s name to maximise the income tax benefits as she only earns £9,000 a year.

HOW TO IMPROVE THE PORTFOLIO

Chris Dillow says:

You say that quality stocks seem overpriced. But the overall UK market is underpriced in that, importantly, the dividend yield is above its longer-term average. This might mean that poor quality stocks are unusually underpriced or you are mistaken to think all quality is overpriced.

One solution could be to shift some of your cash into a tracker fund, which backs the field rather than particular horses – a great virtue. And the proportion of your wealth you should have in equities is a very different issue to which stocks you should buy. Tracker funds allow you to focus on addressing the first issue while you consider which stocks to invest in.

As for how to improve diversification, you are pretty much there. Bonds would protect you against recession risk, but this insurance is expensive. If you hold government bonds to maturity they will lose you money in real terms. And if interest rates turn out higher than the market’s current low expectations, the loss will be especially great. The same is true of gold.

But cash is a decent diversifier. In a recession, it won’t offer the good returns that bonds are likely to. But it also won't lose you money if we avoid recession and rates rise.

It’s probably a good idea to invest in overseas-listed stocks, for the same reason that you might want to consider private equity. Both these assets address the risk that the best long-term growth will not come from companies that are currently listed on the UK market.

The costs of dealing and researching them can, though, be high. So a good way to access them might be collective funds that hold such assets.

Paul Derrien says:

I would aim for each equity holding to account for 3 per cent of your investment pot, rather than 5 per cent – if you hold 20 that would add up to 60 per cent. Given significant outperformance in recent months, now looks like a good time to start working on this by reducing your very large holding in Unilever by half. The cash that this raises could be used to diversify your equity exposure, although I would keep the number of holdings fairly low. Around 20 should be sufficient to provide diversification and keep the amount of research you need to do at a manageable level. And you could add to direct shareholdings that you like. 

You could also use the proceeds to diversify your investments globally or add thematic exposure via active funds or exchange traded funds (ETFs). Options include Lindsell Train Global Equity (IE00BJSPMJ28) and Evenlode Global Income (GB00BF1QMV61).

I would invest £250,000 of your inheritance money in non-equity investments which generate better returns than cash to diversify the equity risk. Put this into Isas each year. Some of this could be invested in index-linked corporate bonds such as Severn Trent RPI-LKD NTS 11/07/22 (SVTL) and National Grid Sterling RPI LKD BNDS 06/10/2021 (NG1Q), and short-dated bonds such as Premier Oil STG DEN 6.50% NTS 31/05/21 (PMO1), Tesco 5.00% NTS 24/03/23 (32UM) and Intermediate Capital 5.00% STG NTS 24/03/23 (ICG3).

Funds such as RIT Capital Partners (RCP) and Personal Assets Trust (PNL) could be alternatives to more traditional equity and fixed-income funds because they invest in a range of different asset classes and their return profiles are less volatile (see below).

Graham Spooner, investment research analyst at The Share Centre, says:

Taking a long-term view via a buy-and-hold approach is fine, but don't fall in love with certain shares. Markets are cyclical and there will be times when difficult decisions have to be made. So if, for example, you believe that your position in Unilever is too large, reduce your holding in it over time. You should be more comfortable selling it at the current strong share price.

And anyone who tells you that they have got out of shares at the top is very lucky or being economical with the truth.

We always stress the need for diversification and there are many ways in which this can be achieved, but you must be comfortable with your choices. You want exposure to overseas listed equities to provide diversification but have limited free time, so I would suggest getting it via investment trusts. Despite your concerns on active funds you should be able to see what their holdings are [in their annual reports] and more concise information [including their 10 largest holdings] on their monthly factsheets. Investing overseas via a specialist team with knowledge of these markets and companies seems appropriate.

If you are struggling to find value and think much of the market is overvalued you could drip-feed money in, using your full annual Isa allowances over the next four years [which are currently £20,000 per person]. If there is a market correction you will be well placed to take advantage of it.

However, trying to buy shares at the right time is always difficult so, if you want to try to get each of your holdings to account for 5 per cent of your investments, I wouldn't try to be too clever with your timing. One option is to buy less of a security if you think the price is high and more when you are more comfortable with the valuation.

Your portfolio offers a balance of income and growth. But if in future you want a bias to shares with higher dividends, you may need to go slightly overweight certain higher income shares such as GlaxoSmithKline (GSK), HSBC (HSBA) and Pennon (PNN), and underweight ones with a lower yield such as Experian (EXPN), Intertek (ITRK) and Diageo.