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How To Easily Build, Manage and Run

a Successful Stocks & Shares ISA

What is a Portfolio

One of the main aims of a portfolio is to make sure that all your eggs do not go in the same basket. This is achieved by allocating money to different asset classes, of which the four main ones are:

  1. Equities
  2. Fixed Income Securities such as Gilts or Bonds
  3. Property (in the form of Property ETFs)
  4. Cash
Within the four major classes there are also sub classes of assets and then sub classes of these. For example, with equities you have UK shares and foreign shares, and these can be then split into developed and emerging markets and so on.
Stocks should form the foundation of your portfolio
Stocks and shares over the years have proved conclusively to be the best asset class for any portfolio, and there is no reason why this shouldn't continue in the future. But how much should one invest in this asset class?

Equities have a higher risk-reward profile than say bonds or cash, so one of the aims of a well constructed portfolio is to have a higher proportion of equities in your portfolio when young (you can afford to assume more risk) and to reduce the weighting as you get older.

Fortunately, there's a simple equation, the 'Percentage Age Rule', which can be used to determine the right mix of assets in a portfolio depending on age.

How the 'Percentage Age Rule' works
To find the right mix of equities for your ISA portfolio take your present age and subtract it from 100 and invest the percentage result in equities, in our case ETFs.
  • If you're 30 look to invest 70% (100-30) of your total pension fund in equity ETFs, or
  • If you're 55 the amount will be 45% etc

What this simple rule achieves is that it allocates your ISA capital into the higher reward type investments (stocks) at an early age and starts to automatically switch this allocation to lower risk income producing investments as you mature (bonds and maybe cash etc).

Basically the younger you are the more risk you should assume (hence the chance of higher rewards) and this risk should be gently diluted as you age.

The best portfolios make use of common sense
Unfortunately there is no perfect theory to use when constructing a portfolio. Yes, there are many academic studies published, with the most famous being Modern Portfolio Theory (MPT) introduced by Harry Markowitz back in 1952.

The basis of Markowitz's work was that it's important to diversify money across a range of different assets. However, the amount that should be allocated to asset A versus asset B, C or D is still very much open to debate and it will always be so.

What I suggest is using common sense.

We have the four main asset classes and we know that stocks have been the best performers, and are likely to continue to be over the longer term. So according to our age we should invest a significant proportion of our pension money into this asset class, with the balance of the money going into the other 3 classes, bonds, property and possibly even some cash.

The table below offers some ideas of the possible weighting of your portfolio in relation to your age.

Portfolio asset allocation percentages depending on age
Age
Equities
Bonds
Property
Cash
Total
20
80%
5%
15%
0%
100%
25
75%
5%
15%
5%
100%
30
70%
5%
20%
5%
100%
35
65%
10%
20%
5%
100%
40
60%
15%
20%
5%
100%
45
55%
20%
20%
5%
100%
50
50%
25%
20%
5%
100%
55
45%
30%
20%
5%
100%
60
40%
35%
20%
5%
100%
65
25%
50%
15%
10%
100%
So a 40 year old should therefore have the following asset allocation in his portfolio -
  • 60% of assets in stocks (ETFs)
  • 15% of assets in bonds (also using ETFs)
  • 20% of assets in property (in the form of property ETFs), and
  • 5% of assets in cash yielding the best interest rate possible
If you look at someone who's 50 the table suggests allocating 50% of assets to equities and some might argue that this is on the high side.

But as this portfolio allocation model is only a guide, it would be fine to reduce the stocks allocation down to say 45% and Bonds up to 30%.

As I have already indicated there is no definitive answer to constructing the perfect portfolio but if you just use common sense you won't go far wrong.

All equities are not the same
Just as there are different asset classes in a portfolio, such as equities or bonds, there should also be different classes within the equity part of the portfolio. Allocating money to different Stockmarkets is very easy to do with ETFs.

Stocks and individual Stockmarkets have their own risk reward profiles. For example, FTSE 100 stocks have a much lower risk/reward profile than say Chinese or Brazilian stocks. It's highly unlikely the London stockmarket will fall by 50% or more over a year (or rise) but in emerging economies such as Brazil and China this is not only possible, it's happened more than a few times in the last several years.

So picking which stockmarkets is a judgement call down to your own preferences and overall financial position. If security is more important to you then go for lower risk stockmarkets such as the major western ones. Or perhaps you want to keep everything British and only invest in the UK market. But if you're willing to accept more risk for the potential of much higher rewards then allocate more money to the emerging markets.

What is 'portfolio rebalancing'
As the percentage mix of assets moves around in relation to your age portfolio rebalancing has to be carried out over time. For example -
  • If somebody is 30 their equity allocation should be 70%
  • But this will drop to 69% when they hit 31

Here lies a small problem with the 'percentage age rule' because if followed literally every year things can start to get a little messy and even trivial when dealing with ISAs valued at less than £20,000.

For example, if your ISA is worth £15,000 and you age from 40 to 41 the equity allocation moves from 40% to 39% with the 1% equating to £150. It's therefore only common sense to rebalance your portfolio every few years.

But don't get too worked up about points like this, just focus on getting the balance of a portfolio generally right in relation to your age. Does it matter if you own 1% or 3% more of a certain asset than you're supposed to?

Cash: Should it be part of an ISA portfolio?
Although cash is an asset class it's very much a judgement call as to whether you keep any on hand as part of your ISA portfolio. There are 2 main reasons to keep cash -
  1. Because you think it's the best asset class at the current time (and for the foreseeable future), and
  2. You want to keep some of your powder dry in case a tempting investment comes along
However, keeping cash within a Stocks & Shares ISA can cause trouble as all ISA money is expected to be allocated to investments. In certain cases I believe the Inland Revenue has made an example of people whose ISAs were predominantly invested in cash for several months.

For this reason if cash is going to be one of your asset classes be smart and use a Cash ISA. The added bonus to this would be the interest rate received will be much better than whatever a Stocks & Shares ISA pays (if they actually pay any interest higher than 0.1% on cash balances).

Summary
The main message I've tried to convey is that portfolio building relies on common sense. It won't pay to get excessively complicated or scientific, but at the same time the value and risk attached to your ISA can be negatively affected if you don't diversify its assets.

The risk/reward ratio is also of critical importance to understand and respect especially if you're new to investing.

Want higher returns, then you have to assume higher risk and there's little if anything that can be done to break this relationship. So don't fall into the trap that many new investors find themselves in - thinking this game is all about profits (reward) when in reality it's mainly about risk, or more specifically controlling it.


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