How I construct a Compound Income Portfolio.

This is the third and final part in my series of articles looking at the why, what and how of Compound Income. As the title suggests this one will look at how I approach portfolio construction.

So lets start at the beginning - which seems like a good place to start. This was when I started investing seriously in a Portfolio when self select Personal Equity Plans (PEP's) first became available in the early 1990's. Prior to that I had had a few shorter term investments in some early privatisation stocks like BT and BG and traded a few other stocks in a small way for some quick profits and held a few investment trusts.

With the arrival of PEP's I decided to get more focussed on building a portfolio in a tax free environment as I wanted to maximise my after tax total returns and this seemed to be the logical place to do it. This was even though I had a CGT allowance and the amount was limited to £6,000 so the savings in tax were not that great upfront, nevertheless I felt the long term benefits would be worthwhile, although I intend to come back and debate this in another post at some point.

So out of necessity I started small and split the modest sum between 2 or 3 stocks, accepting that this was risky and under diversified. I took a long term view that I would build the number of stocks up as each years allowance came and the income compounded up. Thus over time I built the portfolio up, gradually increasing my unit size (value of holding) and number of stocks as the years went by. However, as it is generally accepted that you can diversify a large majority of the market risk with just 15 holdings I have not gone too much further than this number of stocks in my PEP or ISA as it now is. So once having built it up to a reasonable level I have tended to run it with between 20 and 30 stocks. This seems to conform to conventional wisdom that this is a sensible number of stocks to focus on and gives a reasonable level of diversification, although I'm sure some would disagree and argue for a much lower number.

What I have tended to do and still do today is run a broadly equally weighted portfolio, which given the number of stocks I hold gives my portfolio a natural bias to small and mid cap stocks, which research has shown outperform over time. As previously discussed I also focus on value, quality and yield as these are also out performing factors. I also tended to focus on small caps as there are more undervalued and under researched opportunities and buying these stocks did not conflict with my work. However, I do not do this exclusively and I have and still do invest across the market cap spectrum right up to mega caps. In fact I tend to be driven by where I find value and yield in the market at any one time. So for example when the market has taken a beating and small caps have fallen hard I tend to load up on them if I find more opportunities there. Conversely when they have done well and are on a premium, I tend to rotate into better value larger stocks. 

This brings me onto market timing, something which I wrote about recently. As mentioned in that post this is not something that I have generally tried to do to any great extent as I try to benefit from compounding by being in the market. Additionally in a self select ISA, if you went all into cash for an extended period of time you could fall foul of the regulations and potentially lose all the benefits. So what I have tended to do is realise one or two units when markets get frothy and wait patiently for a better opportunity to present itself. This however has served as an example to me of the difficulties of market timing as I have often then found myself having to find a small cap opportunity that has lagged the subsequent move back up in the broader market when I have been too cautious and missed the market low. Beyond that, as discussed above, I tend to shift the emphasis of the portfolio either more defensive or more aggressive depending on where the market is in terms of bull and bear market trend and valuations. For example I have recently been reducing risk in my portfolio by selling out of geared investment trusts where the discounts have gone.

Outside of my ISA while I was working I tended to focus on tax efficient investments such as BES schemes and their successor VCT's plus capital growth investments to utilise my CGT allowance. The VCT portfolio I built up by also utilizing dividend reinvestment plans. These now give me micro cap and unlisted exposure and a decent level of tax free income. Since quitting the rat race and taking a decent slug of cash out of the housing market I have built up portfolios outside of my ISA taking advantage of the value opportunities available in 2009 onwards. In these I have broadened out my portfolio to include extra stocks in addition to those in my ISA. I have also added other assets classes and markets via investment trust and ETF's to add further diversification to my overall portfolio and income sources. This works for me as I have the time, experience and inclination to do it this way and having a more broadly based portfolio helps me to make much more balanced and objective views than if I had a very focussed portfolio. It also means that if one of my investments disappoints or should cut its dividend it does not have too much impact overall. I guess it also means I don't have maximum exposure to my big winners, but at the end of the day I'm looking for a steadily growing income in real terms and if I achieve that the capital side tends to follow. It also means I don't get too hung up on price volatility which helps me be more sanguine during downturns as I know my type of stocks and diversification should make my portfolio more resilient and compounding much of the income helps to speed the subsequent recovery.

Thus I then monitor my portfolios for news flow and result to make sure that all is well and that the dividends are increasing as I would expect. If they do not and the trading outlook and financials have deteriorated such that there is a threat of dividends being cut then I will tend to exit. As long as there is no serious deterioration or risk of a dividend reduction then I am usually happy to run with a stock if it still offers decent value and yield as quality shouldn't change over night. Thus my sell discipline is driven by those factors (value, yield dividend growth and financial security) and if a more attractive opportunity comes out of my screening process. I therefore tend to have low turnover of around 20 to 30% per annum and even then some of that turnover is driven by income reinvestment and tax planning. 

So much of the time it involves monitoring the portfolio and masterly inactivity and as Rockefeller said nothing gives me greater pleasure than seeing my dividends come in. Even if it is only electronic digits in a bank account rather than cheques these days. I would characterise it as a get rich slow and steady type of approach, which may not be to everyone's liking and indeed may not be the best way to get rich - but more on that another day. 

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