What is Sequencing risk? (part 2)

In part 1 of this article, I examine the impact of poor investment returns or losses on your investment portfolio, at a time when you are counting on them, or need them the most. This poor return at the wrong time, is described in investing circles as ‘Sequencing Risk’. At other stages of life your investments may have performed quite well.

In fact it’s important to realise there can be fortunate periods of time when you experience good investment returns, at precisely the right time. For example between 1980 and even through the 1987 stockmarket crash into the late 1990’s there were such strong sharemarket returns that a retiree back in 1980 spending what they would have expected to spend each year in retirement, would still have the same retirement savings amount in place after 20 years in retirement.

The facts

The fact is that investment and financial advisers, product providers, banks and the media DO NOT KNOW what the next 5 years holds. They do not know the order or sequence that your investments will experience. They cannot say whether your investments will grow at first, decline next, and then recover later; or decline when you first start investing, then grow fast or even stay the same, with little or no return for a few years.

The investment community is likely to suggest however, that if we have just emerged from a protracted decline or correction in the market – the chances are that the next 5 years investments will look a whole lot brighter! Why? Because the investing community keeps in mind actual performance over a long time period – and they can recall the good periods of growth, and be confident they will return.

Many advisers believe that we have to stay forever invested in growth assets because of life expectancy. We are all living longer – average life expectancy dramatically rose in the 20th century. In Italy a male born in 2011 can expect to live to age 80 and a woman 85 (at the beginning of the 20th century the average life expectancy was approximately 55 years of age!)

Considering the average person retires from full-time work aged between 60-65 yrs of age – this means that essentially we have on average at least 15-20 years to rely on our savings and investments or pension.

Now pension money from the government is not significant, and the current and continuing strain on government resources and large outstanding public debt means that pension rules are constantly under review, so government’s are inclined to reduce the public’s reliance on the pension. The fact is State pension obligations around the world are largely unfunded.

So life expectancy, and the traps of relying on a State pension, can be used (by many) to explain why investors ought to “stay invested in growth assets” as it were, and subject to the market’s ups and downs.

However, and as the Global financial crisis has reminded us,  there is a significant Sequencing Risk – especially for retirees and those about to retire.

Growth assets (like investing purely in stockmarket –listed companies and funds) are typically volatile. They can fluctuate up and down over the short term and thereby leave you exposed to sequencing risk).

So how do you deal with this risk and attempt to remove or mitigate it?

Your investing focus potentially needs to change when you arrive 5 years and perhaps even 10 years before retirement. An adviser dealing with clients personally needs to recognise these changes in investing risk – and the changes in his/her client’s attitude to risk when investing at this special time of life, and start to consider allocating assets (investments) in a different way.

Invested money needs to be categorised (or split-up), and portions reallocated to less volatile and income-producing assets.

Consciously making investing adjustments at the right time, changing the balance between growth- focused assets (and especially the most volatile assets) and income-producing assets (those on which we need to rely in the pension years of our lives) is one critical step in reducing the sequencing risk.

Examples of less volatile and income producing
assets include Term deposits, corporate bonds,
REITs, and other fixed income products

You don’t want to be drawing out money from your investment portfolio when the market is down – and drawing out from that portion of your retirement sum or life savings that is the most volatile. You can have a separately categorised basket of investments that provides your source of income (or costs of living), and leave separate a basket of growth assets that is allowed the time to fluctuate with the ups and downs of the market and recover any losses that may be incurred in those pre-retirement years.

Your retirement income stream  (or private pension) should be drawn- down from that part of your redistributed portfolio that is lowest in volatility.

In this way advisers can help you ‘cut-out’ the potentially negative effects of the interaction between cash flow (required every day in retirement) .. and market volatility, which is much more critical to an investor who is considering retirement in the not-too-distant future.

A considered approach, such as the strategy suggested here, can potentially provide piece of mind, and some security in knowing that your pre-retirement years need not be filled with the stresses and fears related to market volatility, which is a natural part of the world of investments.

The above information does not represent financial advice. This is general information and advice which has not been tailored specifically to your needs. You should speak with an adviser to seek personal, specific advice about your own situation, before acting on any information contained herein.

For more information and assistance to create your own strategy that manages sequencing risk proactively, contact me.

photo credit: alles-schlumpf via photopin cc


All thoughts are my own. The information contained here is not personal financial advice tailored to individual needs.