Introduction
MANAGING INVESTMENT ALLOCATION within the portfolio is one of the most important aspects of investing successfully in the stock market. Despite this, most investment books available overlook this. As a result, few people understand the implications and benefits of managing investment allocation within the portfolio.
Previous chapters have described how to combine fundamental and technical analysis to improve the odds of making consistent positive returns. However, investing is a game of averages and at times there will be periods of loss.
Managing investment allocation helps produce a well-balanced portfolio that is structured to limit potential losses at any point in time. This ensures the portfolio does not become overextended to the point that a large loss (or a general downturn in the market) damages long-term investment returns.
It achieves this by specifying rules on the maximum amount that can be invested in a company, sector or region, relative to the overall size of the portfolio. In addition, allocating money and investments across different accounts allows you to make the most of tax allowances. Reducing the amount paid on taxes will help improve return.
Specific investment risk
Investing too large a proportion of your overall portfolio in a single company is the most frequent reason for portfolio values being severely damaged. To understand why this is the case, consider table 15.1, which shows the percentage gain required to recover from different sized losses.
Table 15.1 Portfolio return required to recover from a loss
|
Size of loss (%) |
Percentage gain required to recover from the loss |
Years taken to recover at 7% return per annum |
Years taken to recover at 10% return per annum |
|
5% |
5.3% |
1 |
1 |
|
10% |
11.1% |
2 |
1 |
|
15% |
17.6% |
2 |
2 |
|
20% |
25.0% |
3 |
2 |
|
25% |
33.3% |
4 |
3 |
|
50% |
100.0% |
10 |
7 |
|
75% |
300.0% |
20 |
15 |
|
90% |
900.0% |
34 |
24 |
|
100% |
Never |
Never |
Never |
The first point to note is that the return required to recover from a loss is always bigger than the percentage loss made. For example, a 10% loss would require the portfolio to return 11.1% to fully recover. Thus, an extra 1.1% return is required to regain the original portfolio value prior to the loss.
The second point to note is that the return required to recover from a loss increases exponentially as the relative size of the initial loss increases. This means that the bigger the loss, the longer and harder the remaining assets will have to work for the portfolio to return to its original value.
The third column of the table shows the number of years (rounded up to the nearest year) that it would take to recover from different sized losses based on an annual return of 7% per annum in the future. (Here, we assume the long-term market average return from investing a lump sum in the stock market is 7% per annum.) A loss of more than 20% will take more than three years for the portfolio to recover.
Consider the extreme case of a portfolio being fully invested in a single company. Should the company become worthless overnight you would lose all the money invested and be unable to recover without additional money being added. Of course, complete bankruptcy of a company is an extreme event which is less likely to happen if you follow the advice in previous chapters and select companies that have strong balance sheets.
However, one-off company-specific events can sometimes severely damage a company’s value overnight. For example, BP’s share value plummeted by almost 50% after its Deepwater Horizon oil rig exploded and sank in May 2010. The disaster resulted in one of the largest accidental marine oil spills in the history of the petroleum industry and left BP with substantial costs to cover the environmental and economic damage that had been caused. If the whole portfolio was invested in BP, it would take around a decade for the portfolio to recover, assuming a 7% return per annum return was subsequently realised (see table 15.1).
Alternatively, if 50% of the portfolio had been invested in BP at the time of the disaster, the initial portfolio loss would have been around 25% of the portfolio value. The portfolio would then have had to return 33.3% to recover from the loss, which would take four years, assuming a 7% return per annum. By investing a lower percentage of the portfolio in any one company, the specific company loss is limited and recovery times are improved.
Consequently, if you fully invest in too few companies, such that you take large positions relative to your portfolio, and they start to lose money, it is entirely possible for the value of the portfolio to be severely damaged by big losses which will take a long time to recover from. You should therefore limit the amount invested in any one company.
For portfolios worth less than £500,000, the largest proportion of the portfolio allowed to be invested in a single company is 5%
For example, if the portfolio value was £100,000, then no more than 5% of the portfolio value can be invested in a single company. Put another way, the portfolio should hold no more than £5,000 in the shares of any one company. This ensures that if a company becomes worthless the loss is limited to 5%. The remaining portfolio should be able to recover from this loss in under a year, all other things being equal.
Note, for small portfolios worth less than £20,000, the investable amount is set at £1,000, as otherwise trading costs become too high relative to the amount invested.
For portfolios worth between £500,000 and £1m, the largest amount of the portfolio allowed to be invested is £25,000. This keeps the proportion allocated between 2.5% and 5%
Keeping the maximum investment in a company limited to £25,000, allows the largest percentage invested in a single company to transition from 5% to 2.5%. This allows the portfolio to become more diversified as it grows in size.
For portfolios worth more than £1m, the largest proportion of the portfolio allowed to be invested in a single company is 2.5%
This limits the number of companies in the portfolio to 40, striking a balance between the benefits of diversification and the benefits to returns from a concentrated portfolio.
When the above rules are combined with the techniques discussed in previous chapters, the chance of a significant loss is reduced. For example, if a 20% stop loss is implemented (as suggested in the previous chapter) there is a good chance that the actual loss will be lower. For example, if 5% of a portfolio is invested in a company and the share price falls below the stop price and is sold, the actual loss may be limited to around 1% of the portfolio value, which can be easily recovered.
Sector risk
Sector risk is the risk that many of the companies in a sector (such as financials, health care, basic materials and so forth) will fall in price at the same time because of an event that affects the entire industry.
In this case, price movements in companies within a sector become more correlated (i.e., they tend to move together more) and losses can be compounded. For example, the collapse in crude oil price from over $115 in June 2014 to under $30 at the beginning of 2016 led to sharp falls in value for companies in, or associated with, the energy sector. You therefore want to be well diversified across sectors over time.
To limit the impact of a negative sector event, no more than 20% of the portfolio value can be invested in any one sector. This ensures that in the worst-case scenario, where all of the companies in a sector suddenly become worthless overnight, the loss in portfolio value will be limited to 20%. Better still, should a negative sector event occur, the use of a 20% stop loss means that there is a good chance that the overall loss would be limited to around 4% of the portfolio. A loss of around 4% should be recoverable within a year, assuming an average future return of 7% per annum.
Of course, the above assumes that only one sector is affected. In some cases, a negative event may affect one or more sectors. If more sectors are affected, the potential losses could be larger but would still be limited to no more than 20% of the total portfolio, due to the use of the 20% stop loss. In this extreme case, it would take around three years for the portfolio to recover, if future returns averaged 7%.
Position risk
Position risk is the percentage of the portfolio value that is potentially at risk of loss from an investment in a single company, should its stop loss be hit. (The possibility of a catastrophic event that collapses the value of a company too quickly for a stop loss to be effective is excluded – this risk is dealt with in the specific investment risk section.) Limiting position risk to a reasonable level helps to reduce losses from any one company.
The initial position risk can be calculated by multiplying the percentage stop loss and the amount invested in the company (to obtain the value of the position that is at risk of loss) and then divide by the current value of the portfolio.
For portfolios worth less than £500,000, the maximum position risk allowed is 2%
For portfolios between £500,000 and £1m the maximum position risk is set at £10,000
The maximum position risk allowed in percentage terms starts at 2% for portfolios valued at £500,000 and steadily declines to 1% as the portfolio size approaches £1m.
For portfolios in excess of £1m, the maximum position risk allowed is set at 1%
Using these maximum position risk rules, you can calculate the maximum amount that can be invested in a single company. The amount is calculated by multiplying the position risk by the portfolio value and dividing by the percentage stop loss. Thus, if the stop loss is set at 20% (as recommended in the previous chapter), the maximum amount that can be invested in a single company is five times the position risk multiplied by the portfolio value.
Example
Suppose the current portfolio value is £100,000 and you are considering buying shares in a company. Following the rules, the maximum position risk is set to 2%. This means that the position value at risk of loss is limited to £2,000 (= 0.02 × £100,000). If a 20% stop loss is used, the maximum amount that can then be invested in the company’s shares is £10,000 (= 0.02 × £100,000 ÷ 0.20). Note that this is five times the position value at risk.
Changes in position risk
While a position held in a company is making a loss, the position risk will remain the same so you should limit purchases to the total value allowed. However, once the shares have risen sufficiently in price, a trailing stop can be put in place that is above the breakeven purchase price for the shares. (Deciding how and when to use a trailing stop is covered in the previous chapter; however, a profit will normally be locked in once the share price has risen 11% above the breakeven price.)
Once the stop is above the breakeven price, an expected minimum profit is locked in and the position risk is now zero. This allows an additional position to be added to the company, provided the specific investment and sector risk rules are satisfied. The additional investment amount allowed is based on the value of the portfolio at the time the investment is being considered.
Example
Continuing the previous example, suppose £2,500 was spent on a company and the share price subsequently rises sufficiently for a trailing stop loss above the breakeven price to be put in place. At this point, the current position risk in the company is zero, and a further investment may be added.
Suppose the value of the shares rose by 20% to £3,000, and that a stop loss is now placed above the breakeven price (according to our selling rules, mentioned in the previous chapter). The portfolio value, all other things being equal, has risen to £100,500.
The position risk rule limits you to a 2% position risk, which means that an additional £10,050 (= 0.02 × £100,500 ÷ 0.20) of shares can now be purchased in the company. The specific investment risk rule limits the amount invested in a single company to 5% of the portfolio value, which equates to £5,025 (= 0.05 × £100,500). As £3,000 of the company is already being held in the portfolio, the additional amount that can be purchased is limited to £2,025 (= £5,025 – £3,000).
Portfolio risk
Portfolio risk is the percentage of the overall portfolio value that is potentially at risk from all of the companies invested in, when stop losses are being used. Portfolio risk is therefore the sum of all open position risks. Limiting the amount of portfolio risk helps to protect the portfolio from a catastrophic collapse in market value, where share prices fall together.
Portfolio risk is not allowed to be more than 15% of the total portfolio value. This ensures that a severe market drawdown, which results in share price losses of more than 20%, will typically be limited to around a 15% loss on the portfolio. Referring to table 15.1, a 15% loss on the portfolio can usually be recovered within a few years, assuming an average 7% return per annum.
The number of open positions allowed (assuming that the maximum amount of position risk for each investment is taken) can be calculated by dividing the portfolio risk by the position risk.
Example
If the portfolio value is £100,000, the maximum position risk is 2% and the maximum portfolio risk is 15%. The maximum number of holdings that can still make a loss is therefore 7 (= 15% ÷ 2% = 7.5), which is rounded down to the nearest whole integer.
Using smaller position risk sizes than the maximum allowed permits more open positions to be held. However, in this case, you should cap the number of open positions that can possibly make a loss to 30. This makes it easier to keep track of companies invested in, while managing sell and buy decisions.
Applying the portfolio risk rule means that in down markets the portfolio tends to have a greater proportion in cash; this is because any position entered into at this time will generally remain loss making, so it is better to retain cash rather than buy. In up markets, the portfolio will gradually move towards being fully invested, as portfolio risk will steadily fall as share prices rise, allowing more positions to be added as profits get locked in.
Example
Suppose the initial portfolio value is £100,000, which is held in cash. As in the previous example, portfolio risk will allow up to seven holdings in different companies to be bought.
The specific investment risk rule allows no more than 5% to be invested in any one company, which equates to £5,000.
The position risk allowed is 2% (or £2,000) and combined with a 20% stop loss this implies that the maximum amount that can be invested in a company is £10,000. This is double the specific investment risk allowed.
You therefore take half the maximum position risk allowed for each company invested in. That is, 1% position risk on each trade. Thus, you can invest in up to 15 companies (= 15% ÷ 1%), investing £5,000 in each company. This means that 75% of the portfolio is initially invested in shares and 25% (£25,000) is held in cash.
Suppose that six months later, two of the companies have increased in value by 20% and stop losses have been put in place 5% above their respective breakeven prices; the 13 remaining companies have risen by 5% and their stop loss levels have not been adjusted. This means that the current portfolio value has risen to £105,250 and 76.25% (= (£105,250 – £25,000) ÷ £105,250) of the portfolio is now invested in shares.
Thirteen of the companies still have the same position risk, as their share prices have not risen sufficiently to lock in a profit. Two of the companies have locked in profits, meaning their position risk has gone to zero (i.e., the position risk is closed). Thus, the portfolio risk has fallen from 15% to 13% (= 15% – (2 × 1%)).
The current portfolio value is now £105,250 and the portfolio is carrying a 13% position risk on 15 investments. (The position risk in percentage terms is slightly lower as the portfolio has increased in value; however, it is a convenient approximation to just carry the percentage risk based on initial calculations.)
The specific investment risk rule allows no more than 5% to be invested in any one company, which equates to £5,262.50 (= 0.05 × £105,250). The position risk allowed is 2% (or £2,105) and combined with a 20% stop loss this implies that the maximum amount that can be invested is £10,525.
This is double the specific equity risk allowed and again half the maximum position risk (1%) is risked on each trade. This means that two new positions can be added, with the maximum value allowed in each holding now being £5,262.50. This raises the percentage of the portfolio invested in shares from 76.25% to 86.25%.
Regional risk
Regional risk is the risk that companies located in a geographical region will fall in price at the same time because of a negative regional event or shock. In this case, price movements in companies within the region become more correlated (that is, they tend to move together more) and losses can be compounded. Ideally the portfolio should be well distributed across different geographic regions to reduce this risk and improve returns on the portfolio.
Diversifying across regions can be problematic when selecting individual shares for the portfolio. This is because you need to have access to share screeners that cover shares listed in multiple regions, which usually incurs additional cost. This is less of an issue for high-value portfolios as the relative costs will be small and the techniques outlined in previous chapters will be easily applied to different regions. However, for low-value portfolios, say under half a million pounds, these extra costs can be prohibitively expensive.
Fortunately, there is a relatively straightforward way to check the degree of geographical diversification a portfolio has. The Morningstar website provides the proportion of revenue generated from each region for every listed company, which is accessible from the company stock profiles. This can be used to calculate the amount of portfolio revenue being generated from each region and the regional exposure of the portfolio. You can then try to diversify the portfolio exposure by selecting companies with exposure to desired regions.
Example
Table 15.2 shows the regional exposure of an example portfolio. The number of shares owned and the sales per share are shown for each company in the portfolio. This allows the amount of company revenue attributable to the shares owned to be calculated. This is done by multiplying the number of shares owned by the current sales per share figure (see column 4).
The regional breakdown of sales is available from the Morningstar company profile page; these are allocated to the relevant categories listed in the table. If Morningstar does not have a regional breakdown, sales are allocated to the UK. (In the example, Aviva and Hansard Global do not have a regional breakdown and sales are allocated to the UK, as this is where the shares are listed.)
Sales by region is calculated by multiplying the proportion of sales generated in a region by the amount of sales owned for each company and summing them up. The second from bottom row shows the amount of sales in each region.
The proportion of sales attributable to each region is calculated in the bottom row of the table. It shows that 75% of portfolio-owned sales are generated within the UK. This is the largest weighting and is to be expected as the initial focus of the portfolio is on UK-listed companies. However, 25% of the portfolio is generated from overseas.
Table 15.2 Calculating regional exposure
Rebalancing the portfolio
Over time, the make up of companies in the portfolio will change as share prices rise and fall. Over time, some stocks will increase substantially in value, potentially dominating the portfolio, while others will fall in value. Regularly rebalancing the portfolio helps to ensure that the portfolio remains well balanced across a range of companies.
To achieve a balanced portfolio, the portfolio management rules are applied and checked before buying an additional holding of shares in a company. The rules for selling shares (explained in the previous chapter) are followed and when sales are made, this is taken as an opportunity to rebalance the portfolio as needed. This simple approach ensures trading costs are kept low.
Tax efficiency – Allocating money and shares between different accounts
Reducing the amount of tax paid on investments is key to maximising long-term investment returns. It is therefore essential to make the most of personal tax allowances. In the UK, the key tax allowances are for individual savings accounts (ISA), capital gains, dividends and self-invested personal pensions (SIPP). Efficiently allocating money and shares between trading, ISA and SIPP accounts help to ensure these allowances are taken full advantage of.
Individual savings accounts (ISA)
Investing within an ISA protects your returns from tax, particularly if you are a higher rate taxpayer. Although the exact rules around the benefits have changed over the years, all capital gains made within an ISA account are free from tax and do not deplete your capital gains allowance. This can be particularly useful when you have built up a number of years’ worth of ISA investments.
The only downside is that capital losses made within an ISA cannot be used to offset capital gains made outside of the ISA wrapper. In addition, you don’t have to pay income tax on any dividends earned from investments held within the share ISA. (Similarly, with cash ISAs you do not have to pay tax on the interest paid.)
For the tax year 2019/20 the ISA allowance for each eligible adult is £20,000. (That is, no more than £20,000 can be paid into the account each year.) This allowance can be used in a stocks and shares ISA, a cash ISA, or both. This allowance must be used within the tax year; any allowance not used by the end of the tax year is lost. The ISA allowance should be the first allowance to be used and you should try to make full use of the allowance every year.
In the UK, income tax rates are higher than capital gains tax (CGT) rates. It is therefore advised that money placed within the ISA is used to purchase a broad range of income and value shares. Doing this ensures that the ISA account will gradually produce a steady stream of income that is both tax-free and growing. As income grows, the portfolio should experience gradual capital gains as well.
Capital gains allowance
Capital gains is a tax levied on the profits from the sale of assets (including shares in an ordinary trading account) that exceed an annual allowance. The capital gains allowance for the 2019/20 tax year is £12,000.
Capital gains in excess of this level are taxed at the standard rate of 10% in the basic income tax band and at the higher rate of 20% for higher and top-rate taxpayers. For the tax year 2019/20, an individual with income up to £50,000 will fall within the basic-rate taxpayer band, while people with taxable income and gains over this will fall within the higher rate taxpayer band.
Example
If an individual sells some shares from their trading account for £20,000, having bought them ten years ago for £4,000, a capital gain of £16,000 is made. After deducting their annual CGT allowance of £12,000, they will be left with a taxable gain of £4,000.
If this falls into the basic-rate tax band the individual must pay 10% tax, i.e., £400 (= 0.10 × £4,000). If the individual is in the higher rate tax band they will instead pay 20%, equal to £800 (= 0.20 × £4,000). If the taxable gain overlaps income tax bands, then the gain within the basic income tax band will be taxed at 10% and the remainder taxed at 20%.
Once the ISA allowance has been used for the tax year, the aim is to then make use of the annual capital gains allowance as much as is practical. To achieve this, additional earned income should be invested in growth and value shares in an ordinary trading account. Shares from the income buy-list are not used as the aim is to make profits through capital gains, rather than income, which is taxable for higher rate taxpayers.
As the value of shares within the trading account increases, it makes sense to strip out gains from within your annual capital gains allowance as the end of the tax year approaches, rather than letting large gains accumulate over a number of years and eventually result in a large tax bill when the shares are eventually sold. (Note that if you sell a particular share, you must wait 30 days before buying it back if you wish to ‘trigger’ the gain.)
These gains should be transferred to your ISA account each tax year using your ISA allowance. Eventually the growth portfolio will throw off enough cash to fill the ISA each year, creating a virtuous cycle of gains.
Example
Suppose a basic-rate taxpayer owns a range of shares worth £9,000 in their trading account. After five years the shares have doubled in value to £18,000, and after ten years they are worth £26,000.
If the shares are sold in year ten, a £17,000 profit will have been made. Assuming the capital gains allowance is £12,000 (the current figure), the profit is £5,000 above the annual capital gains allowance and a tax bill of £500 (= 10% × £5,000) will need to be paid. Thus, the net profit over the ten years is £16,500.
Alternatively, capital gains can be taken more frequently. If the shares are sold after five years, a profit of £9,000 is made, which is within the annual capital gains allowance and so there is no capital gains tax to pay (assuming there are no other taxable investment gains that tax year). The £18,000 can then be reinvested in other shares and at year ten the portfolio is again worth £26,000. The portfolio is sold and an £8,000 gain is realised, which again is within the annual capital gains allowance. Thus, the net profit over the ten years is £17,000.
From this example, it should be clear that regularly taking gains can save a fortune in capital gains tax over the course of a lifetime. Ideally, capital gains should be taken every few years (and at least once over a five-year period).
Dividend allowance
For the tax year 2019/20, investors have a dividend allowance of £2,000 per person. Dividends in excess of this amount are taxed at 7.5% for basic taxpayers, 32.5% for higher rate taxpayers and 38.1% for top-rate taxpayers (45% income tax band). In addition, the personal savings allowance allows dividends to be protected from tax up to £1,000 per person each tax year. (Higher rate payers get a £500 allowance, and additional rate payers don’t get an allowance.)
After using the ISA allowance, the dividend allowance is useful as you can earn some tax-free income in a normal trading account. This allows you to invest in value companies, which payout a dividend, while waiting for capital appreciation as the underlying company value is recognised.
Hold assets jointly
It is worth noting that if you are married or in a civil partnership and living together, you both have individual ISA, capital gains and dividend allowances to make use of. While money in ISAs cannot be transferred between individuals’ accounts, assets can be shared across trading accounts for yourself and your partner. This means the capital gains (and losses) can be spread across accounts so that you can make full use of capital gains allowances for both of you.
In addition, if you are earning dividend income, make sure your dividend paying shares are shared with your partner. This is so that you make full use of both allowances and ensure that the partner paying the lowest rate of income tax receives the most dividends.
Inheritance tax
While nobody likes to think about their own death, it is worth considering what would happen to your estate should you die. It is good etiquette to have a will outlining who you would like to inherit your wealth as well as a letter (stored securely) detailing all the accounts and assets held. This is so the full estate is readily identifiable and can be distributed to your loved ones through the administrative process after your death.
There are steps you can take to limit the amount of inheritance tax (IHT) paid. There is currently no inheritance tax to pay where an estate (for example, a house and a portfolio of shares) is inherited by a spouse or a civil partner. Where someone else is inheriting, such as children or a sibling, the inheritance tax is payable at 40% on everything above £325,000, or £650,000 where a married couple (or civil partners) have first left everything to their partner and have not used up the £325,000 that everyone is entitled to pass on tax-free.
In addition, there is a main residence inheritance allowance, which provides additional tax relief for direct descendants (children, stepchildren and grandchildren) inheriting a main residence.
For the 2019/20 tax year, the allowance is £150,000, and is set to rise to £175,000 in 2020/21. This means that a married couple with children will be able to shelter an estate worth up to £1m from inheritance tax, provided a residential property is part of that estate.
It is worth noting that unmarried couples are at a significant tax disadvantage. Neither the standard IHT or the residential IHT can be transferred between unmarried couples. Unmarried couples should therefore aim to each own half of their joint assets so that they can be passed down directly on death.
SIPP
Once the ordinary trading account has started to regularly make capital gains in excess of the capital gains allowance and the ISA allowance is being fully utilised every year, it is worth investing in a self-invested personal pension (SIPP). A SIPP is a tax-efficient pension account where you can hold investments in shares, funds and cash (thus sheltering them from tax), while having the added advantage of tax relief on your contributions.
Assuming that you will mainly want to invest in shares, you should find an execution-only stockbroker that offers a low-cost SIPP account. SIPP costs may include a set-up fee to establish the account, ongoing annual management fees and transaction costs.
It should be possible to find competitive SIPP accounts without a set-up fee that charge no more than 0.5% per annum management fees, subject to a maximum amount payable of a few hundred pounds. Transaction costs for sale and purchase of shares should be in line with those paid in an ordinary trading account.
Money invested in a SIPP can be used to buy and sell shares in the same way as other trading accounts. Like ISAs, no tax is charged on dividends or capital gains made within the account. The key difference though is that money in the SIPP cannot be withdrawn from the pension until you are 55. Even when you reach 55, you can only take out 25% of the pension fund value as a tax-free lump sum, while the remainder is taken as a monthly, taxable income. Furthermore, there are restrictions on how the income can be drawn.
When funds are added to the SIPP, you will receive tax relief from the government and your stockbroker (courtesy of the Inland Revenue) will automatically add tax back at the basic rate. For a basic-rate taxpayer (taxed at 20%), a sum equal to 25% of the amount put into the SIPP will be added. Thus, if you want to add £10,000 to a SIPP you only have to pay in £8,000 and the government will pay in £2,000.
Higher and top-rate taxpayers can claim for higher tax relief each year using the self-assessment tax return system. High-rate taxpayers are entitled to a further 20% rebate, while top-rate taxpayers are entitled to a 25% rebate. This means that for every £100 invested by a high-rate taxpayer, the actual cost to them is only £60; the other £40 being paid by the taxman. Similarly, for top-rate taxpayers, the actual cost is only £55, with £45 contributed by the taxman. The extra relief works by expanding your basic-rate tax band by the amount of the gross pension contribution paid, rather than a physical payment of the extra tax due.
The maximum amount that can be contributed by anyone (yourself or your employer, for instance) into all your pensions in a tax year is dictated by the annual pension allowance. For 2019/20, if you are earning less than £40,000 before tax you are entitled to invest the gross value of your salary in your pension each year. For example, if you earn £35,000, you should be able to contribute £35,000 gross to your pension. The payment you make will be £28,000, to which the taxman will automatically add basic-rate (20%) tax relief of £7,000.
If you earn more than £40,000, you are entitled to contribute up to £40,000 gross to your pension each year. If your earnings are above £150,000, the pension allowance is tapered away by £1 for every £2 of earnings in excess of £150,000. For example, if your earnings were £160,000, your annual pension allowance would be £35,000.
You can use up allowances for the previous three tax years if you have not already done so. Under the carry forward rules, you could add your unused £40,000 allowance for the past three years. If you are a top-rate taxpayer, you could receive relief of up to £54,000 (= 0.45 × £120,000).
Contributions above the annual allowance are taxed as income, unless you carry forward unused allowance from the last three tax years. This annual allowance does not apply to any pension transfers. There is a cap on the size of your pension pot and penalties are employed if you exceed the limit. From April 2019, the lifetime allowance is £1,055,000. While this may seem to be a large amount, many will reach this limit in their lifetime.
If you are investing for retirement, SIPPS are more tax efficient than ISAs. For higher rate taxpayers, no tax is paid on earned money invested in a SIPP due to the tax relief. When money is drawn as an income in retirement from the SIPP, most higher rate taxpayers will revert to becoming low-rate taxpayers and the income will only be taxed at the basic rate, which is currently 20%.
In contrast, earned income is effectively taxed at 40% or 50% on money invested in the ISA (as there is no tax relief on money going into ISAs) and money withdrawn from the ISA is tax-free. The case for basic-rate taxpayers is less clear cut, as the effective tax-rate will remain 20%. However, it is still more tax efficient as the lump sum paid out is tax-free.
Despite SIPPs being more tax efficient, ISAs have four advantages that make them preferable when investing for general purposes:
1. ISAs have lower running costs compared with SIPPs.
2. ISAs allow you to access your money at all times, with no restrictions on what you can do with the money; this means a tax-free income can be drawn at any time.
3. The income generated by an ISA does not need to be entered on a tax return, and therefore does not count towards income calculations for tax purposes.
4. ISAs are simpler and currently less affected by government meddling. For example, the government is currently reducing the amount that can be saved in a pension each year and has lowered the maximum threshold before tax starts to be paid. There are also ongoing discussions about further reducing tax relief for higher rate taxpayers and lowering the proportion of the pension fund value that can be taken as a lump sum.
Such advantages make a compelling case to initially invest in ISAs and only begin to pay into SIPPs in later life, when you can afford to lock away money until you’re 55. Due to additional costs, it is only worth investing in a SIPP once you have a lump sum of £25,000 or more available to pay in.
Within a SIPP it is acceptable to invest in income, value and growth shares. For those under the age of 55, a simple strategy is to invest your age divided by 55 of the SIPP portfolio value in income shares and the remainder in value and growth shares. For example, for an investor aged 39, 71% (= 39 ÷ 55) of the portfolio should be invested in income shares and 29% (= 100% – 71%) should be invested in value and growth shares. For those over 55, the portfolio should be completely invested in income shares.
Take financial advice when considering pension options
It is recommended that you consult a financial advisor when thinking about investing in a SIPP. Taking control of your pension ensures there is no ‘top slicing’ of your investment pot by a pension fund manager, but it is sensible to seek guidance on whether a pension plan will meet your future needs and whether your planning is adequate.
Summary
This chapter has outlined a simple system to manage equity allocation within the portfolio that limits the risk of loss and helps to maximise long-term returns.
The portfolio allocation rules ensure that no more than 5% of the portfolio value is invested in a single company when the portfolio value is over £20,000. For small portfolios, trading size is fixed at £1,000 to keep trading costs small relative to the portfolio size. No more than 20% of the portfolio value can be invested in any one sector at any point in time.
An investment in any individual company should never risk more than 2% of the portfolio value. No more than 15% of the overall portfolio may be at risk of loss at any point in time. For large portfolios the position and portfolio risk are decreased in order to ensure a more diverse portfolio of companies.
You should aim to invest in a portfolio of companies with a broad regional diversification of sales across developed markets. This helps to better protect from regional risks or disasters. This may prove difficult for small portfolios since you will likely be focusing on a single regional market, such as the UK, to start with, so as to keep costs down.
However, once the portfolio grows to a sufficient size it becomes cost effective to research companies in alternative regions, which will help broaden the level of regional diversification. It is useful to monitor the regional sales exposure of the portfolio to know where the biggest regional risks lie.
The rules for selling provide a natural opportunity to rebalance the portfolio and ensure it remains diversified. Rebalancing tends to improve returns as it shifts the portfolio away from expensive companies with weakening price momentum and towards companies offering better value and higher returns on average. It also allows you to take advantage of tax allowances and move money into the most appropriate investment accounts.
You should try to make full use of the tax allowances available. In the UK, this includes allowances for ISAs, capital gains, dividends and pensions. Married couples should look to hold assets jointly to make full use of both individuals’ tax allowances. Making the best use of your tax allowance will help to minimise your tax bill and maximise net portfolio returns.