Although it sounds odd, as investors saving to build a solid retirement income, the timing of a good or bad return can be almost as important as the size of the return we achieve.
There’s even a name for this troublesome phenomena – sequencing risk. It refers to the risk investors face from the variable ‘sequence of returns’ they receive from their assets.
And with investment markets continuing to be volatile, sequencing risk is something we’re likely to be facing for some time to come.
So what is sequencing risk?
It’s the investment industry term for the risk that the order and timing of your investment returns will be unfavourable. This is a particular problem if you’re either making cash contributions into your portfolio, or drawing an income from it.
While investment returns can be positive and negative, the order in which they come can have a big difference on the amount of wealth you accumulate.
If your investment returns are poor in the last few years before retiring – even if the average return over the period is good – it can be hard to recover in time and keep your retirement and wealth goals on track.
Sequencing risk is not just important when it comes to retirement, it also affects investors trying to accumulate wealth to achieve a goal at a specific date in the future. This could be paying for your children’s education or tertiary costs, leaving work early, or buying a new home.
Sequencing risk in action
For a simple example of how sequencing risk can affect your portfolio, imagine you invest $150 each year over a three-year period and the average return for that period is 10%.
The chart below shows the very different results you’ll get if the return is 10% each year, or if you received the same average return (10%), but the actual return varies each year:
|Average return of 10% each year||Average return of 10% over three years, but with different returns each year|
|Start of Year 1||$150||Start of Year 1||$150|
|End of Year 1 (+10% return)||$165||End of Year 1 (-50% return)||$75|
|End of Year 2 (+10% return)||$181.50||End of Year 2 (+25% return)||$93.75|
|End of Year 3 (+10% return)||$199.65||End of Year 3 (+55% return)||$145.31|
Sequencing risk can impact anybody who’s investing to achieve a goal at a set point in the future. Whether you’re saving for a special purpose, or investing for income in your retirement, it can change the outcome significantly.
Investors who are either very close to retirement, or actually in retirement, are usually the worst hit by sequencing risk, as experiencing negative returns when your savings are at their highest can significantly impact your retirement savings and how long they last.
If you’re retired, your capital can’t recover like a younger investor’s [capital] can as you’ll be making withdrawals from your portfolio for daily living expenses. Also, you’re unlikely to have additional contributions going into your portfolio to help offset market downturns.
Puncturing your retirement dreams
Sequencing risk also causes heartache if you’re in your last few years in the workforce, as it can mean you end up with less than you expect in your investment portfolio. As the example above shows, a bad return can really hurt your portfolio, even if it’s followed by a series of really good returns.
To overcome this problem, you may be faced with difficult choices. You could have to increase your level of investment risk (by investing in riskier assets) if you still want to achieve your retirement goals by the same date.
Alternative strategies could be to stay at work longer to give your investments time to recover, or cutting how much you spend in retirement.
What can I do about sequencing risk?
Unfortunately, there are no easy solutions as it’s impossible to predict how investment markets will perform over any given time period.
Some of the possible remedies to consider include:
- Increase the amount of diversification in your portfolio.
- Spread your contributions or investments over a long period.
- Adjust your asset allocation away from more volatile asset classes as you age.
- Keep sufficient cash available so you’re not forced to sell assets when markets are low.
- Introduce some capital protection tools (such as structured investments) into your portfolio.
- When an investment return is received is almost as important as the size of the return.
- Sequencing risk is the risk that the order and timing of your investment returns are unfavourable.
- Although a major risk for retirees, sequencing risk affects any investor seeking to achieve a wealth goal at a specific time in the future.
- Pre-retirees may need to work longer if they experience poor returns just before retiring.