Returns of 15 per cent a year are too ambitious

“I appreciate that it’s ambitious, but I’m aiming for an annual average total return of 15 per cent a year until I'm age 57, to take the value of my Sipp up to the pensions lifetime allowance limit," says Matt. “I will put any money I have to invest beyond this into my individual savings account (Isa), which is currently worth about £14,000. When I reach age 57, I plan to move a portion of the portfolio into higher-yielding shares and/or an equity income index fund to provide an income in today’s money of around £20,000 a year.

“I don’t take income from my investments at the moment, and take a buy and hold approach. Although I look for quality companies I also have an eye to value. I first bought Admiral (ADM) and Markel (US:MKL) in 2012, and Mastercard (US:MA) and Visa (US:V) in 2014, and have added to them since. Because of my success with these I have tried to find other high quality compounders at reasonable prices.

"In March I sold my holdings in Seaboard (US:SEB) and Wells Fargo (US:WFC), and used the proceeds to top up Markel and add Moody’s (US:MCO). At time of writing, Admiral, Heritage Insurance (US:HRTG) and Litigation Capital Management (LIT) were closest to the prices at which I’d like to buy more of them.

"However, I’ve struggled to be disciplined and been tempted a number of times by shares that look cheap in terms of their price/earnings (PE) ratio, price-to-book ratio or yield, but were lower quality. But I then sold them or am considering selling them.

"I have a relatively concentrated portfolio because I find that around 15 direct shareholdings is a manageable number to monitor and they’re mostly companies that I’m comfortable holding through any market falls. If I had a greater number it would mean holding companies that I was less confident in.

"I haven’t minded the volatility that I’ve experienced so far and think I'd be able to tolerate a fall in the value of my investments of up to 50 per cent in a bear market. That said, I’ve only been investing since 2011 so haven’t yet invested during a 2008-style crash."

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:

Your aspirations are way too high. Returns of 15 per cent a year are three times as great as we should expect for the market as a whole over the long run. Whereas we might reasonably expect £100 invested in the aggregate market to grow to around £260 over 20 years, you’re hoping it will grow to around £1,600. Such returns would require price growth in real terms of almost 10 per cent a year. But economic activity is likely to grow only around 2.5 per cent a year. This implies that you’re hoping that your claims upon output, which is all shares are, will rise 3.5 times more than output itself over 20 years. So you're expecting your share of the economic pie to increase a lot.

If you're prepared to live with consistent disappointment this is not a problem. But some investors throw in the towel when returns don’t live up to their overinflated expectations and stop investing, missing out on the decent returns the market might offer.

If you want your wealth to grow a lot you have to save – you cannot rely on returns alone.

Sarah Lord, chief client officer at Succession Wealth, says:

It's great that you are very focused on your retirement provision for the longer term. But also give some thought to your short- to medium-term objectives to ensure that you provide yourself with choice and flexibility as you go through life’s journey to retirement.

You already have a reasonable emergency cash fund. So to give you flexibility, save regularly into a stocks-and-shares Isa, drip-feeding money into investments on a regular basis. Doing this smooths market volatility via what is known as pound cost averaging. Regular saving also has the added benefit of instilling investment discipline – whatever markets are doing.

You want a return of 15 per cent a year to maximise your pensions' lifetime allowance. But it is highly likely that there will be changes to pension rules before you get to your planned retirement age in 20-plus years. So your focus should be more on building a balanced portfolio that gives you options, for example, a Sipp and Isa that will provide you with your desired level of income in retirement. This would be better than just trying to max out your pensions lifetime allowance.

You admit that a 15 per cent a year return target for the next 20 years is ambitious, and I think it is fair to say that in the current investment climate it is very ambitious! The Barclays Gilt Equity Study in 2019 found that equities have returned, on average, 4.9 per cent a year since 1899. So reconsider your investment return expectations with a view to average single-digit rather than double-digit returns each year.

You did not invest through the financial crisis of 2008-09. So the recent market volatility due to the Covid-19 pandemic is the first time you have experienced such sharp falls and uncertainty in markets.  Although you say that you could tolerate paper losses of up to 50 per cent, market movements like we have seen recently can be unsettling for even the most stoic of investors.

HOW TO IMPROVE THE PORTFOLIO

Chris Dillow says:

Some of your investments are stocks that have what renowned US investor Warren Buffett calls economic moats – companies with monopoly power. These include such as Amazon (US:AMZN), Mastercard and Berkshire Hathaway (US:BRK.A) – Warren Buffett's investment vehicle. These have undoubtedly been great investments in the past but, the question is, will the future resemble the past?

One reason to fear that it will not is that such stocks are now more richly priced. Whereas a few years ago investors were underpricing the virtues of monopoly power, they have since corrected that error. So although these are good stocks you are paying a premium for them. And their monopoly power might not persist over the long term. It might be broken by technical change, such as new payment methods or changes in the law. For example, in the late 19th century revulsion at monopoly power led to big companies being broken up.

These are small risks in the near term. But we have no way of knowing how great they are over longer periods and history tells us that over 20 years many apparently blue-chip stocks fall into decline.

Your other investments are focused on US insurance companies. These have one thing going for them – they tend to be low-beta stocks as non-life insurance is a utility-type business. This is good, because history shows that defensive stocks tend, over time, to do better than they should and there are reasons to believe that the outperformance can persist.

But this is not a reason to put all your eggs into the basket of one industry. This exposes your portfolio to the danger that the sector might become more onerously regulated, and incur contagion and tail risk. If one company goes bust, as some insurance companies have, investors would worry which one will be next and this would drag down the share prices of the whole sector.

So I suggest that you diversify your investments more. You don’t need to research companies before doing this. There’s nothing wrong with parking money in a tracker fund until you think of something better, and many investors don’t think of anything better.

Ian Forrest, investment research analyst at The Share Centre, says:

Your aim of a 15 per cent a year return for the next 20 years is extremely ambitious. Most investors are lucky if they get more than 5 per cent unless they’re willing to take an exceptional level of risk. You appear to happy to take some risk. But if you need the money for important future goals such as retirement you might be forced to crystallise a large loss.

Your portfolio is heavily weighted to financial services, especially insurance, and the US. A heavy weighting to the shares of financial companies increases the risk level of the portfolio and will make it harder to achieve your annual return target as insurance is traditionally a sector that is better for income than capital growth. Having so much in one sector also means that you are depriving yourself of the opportunity to benefit from more growth-orientated sectors, such as healthcare and technology.

Although Admiral has performed relatively well in recent times, and should benefit from fewer claims during the Covid-19 lockdown, I would still discourage you from adding to this as more doubt about dividends has been raised. I would also suggest reducing your holdings in Mastercard and Visa, which account for more than a quarter of your investments [minus the cash]. For most investors, a medium risk position is around 10 to 15 per cent in any one stock or sector. You have increased your investments' risk with your current allocation so would be better not adding any new holdings in financial services. Instead, switch into funds that focus on other sectors and regions outside the US.

Your UK exposure is relatively small, but with valuations of this market looking relatively good at the moment it could be worth taking advantage of them. Also increase your exposure to emerging markets, where long-term growth prospects are far better. Given the high level of uncertainty at present it would be best to drip-feed money into investments as it is likely there will be more market volatility in the coming months. 

Sarah Lord, chief client officer at Succession Wealth, says:

Your portfolio is not particularly diversified. A properly diversified portfolio can reduce risk and volatility without necessarily giving up returns. So I would encourage you to introduce exposure to other asset classes such as corporate bonds and gilts (UK government bonds), which can help to dampen the impact of investment market volatility. You could gain this exposure by investing directly or through a fund, which would provide an added layer of diversification.

You could build exposure to different asset classes via regular investments. This would mean that you gradually diversify your portfolio rather than risk trying to time the market at a time when it remains volatile. No matter what lies ahead, a focused discipline, proper diversification and perseverance over the long term are very important.