Where can I find low-risk, high returns?

“Our living costs amount to about £50,000 a year, but my pension income of £6,000 and rental income only come to £26,000 a year," says Zachary. "My wife has just started an enterprise to help the underprivileged and poor, and pays herself a stipend of about £11,000 a year. As she is 52 it will be some time before her pensions start to pay out. So we supplement our income with the proceeds from the sale of a property my wife owned, but this money will run out in about 18 months.

"Therefore I would like my investments to make a total return of between 3 and 5 per cent a year to cover our income shortfall. I would also like them not to lose their capital value, or at least not fall more than 5 per cent a year in value. As my wife is much younger than me, I would like to provide for her and my son after I’ve gone, so I am leaving the assets to her and subsequently to my son. 

"I have been investing for 10 years and, until recently, took a buy-and-hold approach and was fairly heavily invested, with only £55,000 in cash. But I felt that markets were becoming rather volatile late last year so – luckily – I reduced my investment exposure before the coronavirus outbreak and subsequent market plunges, and now have cash worth around £306,585. So what should it be invested in - what would be safe and generate a bit of income?"

NONE OF THE COMMENTARY BELOW SHOULD BE REGARDED AS ADVICE. IT IS GENERAL INFORMATION BASED ON A SNAPSHOT OF THIS INVESTOR'S CIRCUMSTANCES.

THE BIG PICTURE

Chris Dillow, Investors Chronicle's economist, says:

You share a dilemma with countless other investors – how to achieve a safe income, given that bonds and cash pay so little while equities are too risky. 

You can solve this problem, up to a point, with two key tenets of financial economics. 

Firstly, what matters is total return, not dividends. You can create your own income by selling assets, and often tax-advantageously because everyone in the UK has a capital gains tax (CGT) allowance [£12,300 for the 2020-21 tax year]. And what matters is your portfolio as a whole. Losses on one asset are tolerable if they are offset by profits on another. This is especially relevant now because cash doesn’t pay interest of 3 per cent to 5 per cent, which is what you want, and although equities might they have a greater risk than you are willing to bear. So the solution is a balanced portfolio.

Jason Porter, business development director at Blevins Franks Financial Management, says:

You are UK tax resident and your wife is a South African tax resident. You are unlikely to be a South African tax resident under that country's ordinary residence test and it is relatively easy to avoid tax residence under the South African three-part physical presence test. But it would still be worthwhile having discussions with both UK and South African tax advisers to confirm your position and set out some dos and don’ts for you going forwards. 

Your and your wife's combined income is £37,000 a year, but your annual outgoings are roughly £50,000. You have not said whether your incomes are after annual tax, but you need to take account of this – as well as taxes which would be deducted or payable on future investment income and gains.

It is often the case that an investor's portfolio holdings and asset allocation does not match their stated aims and goal. Excluding the cash, your portfolio suggests that you have a high capacity for loss and a high risk tolerance. But this is at odds with your desire to preserve as much capital as possible while generating an income to provide for your family. We would suggest going through a risk profiling exercise with a professional adviser to clarify your risk tolerance. This could reveal that you have a risk tolerance that is much lower than that of your current portfolio and more in line with your investment goals.

Your portfolio and cash holdings are likely to be generating a yield of around 1 per cent overall. This falls far short of your stated goal of 3 per cent to 5 per cent with low volatility. But there are two ways to get income: from your investment payouts or by taking profits generated by high-growth funds. However, the second option relies on being able to weather moments of volatility and potentially draw less income at times, which does not seem to fit your goals.

Robert Ward, investment manager at Walker Crips, says:
I will first address your investment objective and risk tolerance. In the current low interest rate environment, getting an income of 5 per cent a year without taking the risk of losing capital is impossible. To achieve a rate of return higher than that of cash you need to put your capital at risk.

You want to bridge the difference between your income and expenditure of £50,000 a year and have approximately £439,000 to assist you with this. Think hard about any cash requirements you might have over the short to medium term, and ensure that this amount is held in an easy-access account so you can draw on it when required. This would mean that you needn't be concerned over what global stock markets are doing at that point.  

The assets in your individual savings accounts (Isas) and trading accounts could provide you with about £250,000 to invest, leaving £190,000 to set aside. You would require a net return of 5.2 per cent a year from the invested £250,000 to achieve the £13,000 a year you need. But to generate 5.2 per cent a year [you would have to invest in assets of which] the value will vary and possibly decrease, so you would have to be comfortable with this.

The Covid-19 outbreak has thrown up many challenges for income investors, as many companies are cutting dividends, making it harder to get a natural yield. Your investments are largely equity based, so I suggest a more diversified investment strategy whereby you hold a range of asset classes. These could include infrastructure and income-yielding multi-asset investments, alongside more conventional assets such as fixed interest and equities. This would reduce the correlation of your investments with each other and the likelihood that your income will be negatively impacted.

As global markets are in bear territory it is tempting to wait before investing. But markets may rise, so if you wait you could enter at a more expensive point. Market levels are based on price-to-book valuations, meaning that, historically, investors have had a good chance of a very healthy annualised return if they hold for the long term. So ignore the short-term noise and gradually phase money into a diversified range of investments that you are prepared to hold for the long term. If you wait you might have to meet your income deficit with capital withdrawals, which you do not want to make. When you have a diversified asset allocation in place, make sure that it is balanced and monitor it continually. However, evaluate performance over a sensible long-term timescale. As your wife’s time horizon for investing is much longer, consider that and be less afraid of short-term volatility. 

HOW TO IMPROVE THE PORTFOLIO

Chris Dillow says:

The biggest part of a balanced portfolio should be equities as only these will give you the total return you need - with average luck. And you do not need to try to pick out the ones that will as you can invest in a global tracker fund. This is, in effect, a fund of all the world’s equity funds and what you should hold as your default equity investment if you are not sure about where to invest. Often it is hard to have a better idea of where to invest other than this type of fund. Sometimes, it’s sensible to let the market do your thinking for you.

But this position should be balanced out by other assets, including government bonds, which you can invest in [cheaply] via exchange traded funds (ETFs). These should rise in some of the circumstances in which equities fall, for example if investors become more nervous or if the world economy looks as though it is going to do worse than expected.

A rise in bond prices, however, is a mixed blessing. It means that yields fall, implying your future income will be lower. We can protect against this by holding gold because its price tends to rise when bond yields fall, providing additional capital gains. Also, when investors become really nervous and dump equities, they tend to sell riskier currencies such as sterling and the South African rand and buy US dollars – in which gold is priced. So rand or sterling-based investors who hold gold could benefit from a capital gain. For this reason you should also try to hold some foreign currency as well because the diversification benefits of gold and bonds are imperfect. Losses on equities might outweigh profits on gold and bonds. Or if investors fear rising interest rates such assets will lose value at the same time. So also hold some sterling or rand cash.

Such a portfolio would experience losses on some assets. In better times, equities would rise while gold and bonds would fall, and vice-versa in worse market conditions. This is the essence of diversification. If all your holdings go up, you’ve gone wrong because you haven’t spread risk.

A portfolio with this kind of asset allocation has experienced low volatility in the past, as I pointed out in my comment on How not to lose money in the issue of 17 January. And although there is no guarantee that it won't ever fall 5 per cent or more, such an allocation greatly improves your chances of getting a steady income.

Jason Porter says:

Your current portfolio is invested in concentrated funds run by high-conviction equity managers such as Baillie Gifford and Lindsell Train. These funds' 10 largest holdings account for a significant portion of their assets, which makes them susceptible to significant volatility if a few of these stumble. The 'bottom up' stockpicking approach [choosing stocks on the basis of their own merits] employed by their managers has been very successful in recent years. However, the high-risk, high-reward nature of these funds no longer seems suitable for your entire portfolio in view of your stated objectives of income and low volatility.

Your investments are primarily equity funds with a growth bias. By diversifying into different assets you could generate a higher yield and lower the volatility of the portfolio. So we would suggest having a well-balanced, multi-asset portfolio with several growth drivers and sources of return. Bond funds could play an important role because they could help you meet your income objectives and decrease the portfolio's overall risk.

For example, several sterling corporate bond funds and global government bond funds have annual yields of around 3 per cent and significantly lower volatility than equity funds. Further up the risk scale, high-yield bonds can offer higher yields with a level of volatility closer to equities.