VALUE INVESTING
Child's Play

By Stephen Bland (TMFPyad)
January 21, 2005

A reader asked recently about investing a modest sum of money, around £2,500, for young children. The answer to such questions depends initially on the degree of risk the investor wishes to take. I would advise the risk averse to remain in cash investments such as a deposit account or maybe a dated gilt, level or index linked.

In contrast to many people, I don't think that cash is such a bad investment. There are quite lengthy periods when it will beat the stock market. Anyone who invested a lump sum when the market was much higher some years ago will certainly be losing out quite heavily compared with cash. And to rub it in, the cash investor has had no risk, so on a risk adjusted basis cash would have been an even better choice. I know in the recent short term, the stock market has done well, but this is not the point. Shares are promoted as longer term investments, certainly at least five years.

It is easy to say now of course with hindsight that the market has lost to cash over the last few years, I accept that. Will the stock market beat cash by a sufficiently decent margin to justify the risks over the next, say, ten years? I dunno is the short answer. And the long one too.

I am as certain as it gets, and nothing can ever be certain in the stock market, that for those prepared to accept the risks of equities, a high yield portfolio (HYP) will leave the broader market well behind long term. And that this is even more the case on a reinvested income basis for those using the strategy for growth.

So, my answer to our reader seeking an investment for children was a five-share 'HYP Lite' simply because the available money was far too little for the usual 15-20 share HYP. The construction rules for an HYP Lite are similar to the larger portfolios regarding diversification but clearly, holding only five shares attracts more risk both to income and capital than fifteen shares. But I don't think it that risky to hold a small portfolio of blue chip shares. You can find some very substantial companies in their different fields with a common denominator, high yield compared to the market.

In this situation, with the modest sum and the lengthy period available for investment my view is that this is a risk well worth taking. With a five-share HYP, a pretty high start yield of around 5.5% at least could be obtained. Compounding this sort of income over many years will alone produce a good return - assuming maintained or increased dividends - but add to that the potential for capital growth and you have a recipe for a pretty good investment in my opinion.

Funds have their place for some types of investor, such as those not prepared out of fear to hold individual share portfolios or perhaps those investing very small amounts monthly for whom it would be impractical. There are also some who believe that index tracking funds are the most attractive way to invest in shares, because they feel that no other strategy stands a sufficiently good chance of beating them to take the risk. Whatever irons your shirt.

I though will continue to believe without doubt that HYPs are much superior to index trackers over long term, delivering substantial outperformance at a similar or lower risk. At least until I see some evidence that they are not. And I'm not holding my breath.

You can read about the performance of my public HYPs 1 and 2 here on the Motley Fool in the regular updates I publish every couple of months.  In my subscription Value Investor newsletter, I am constructing new high yield portfolios for readers by adding one new selection each month.