Most people understand that volatility in financial markets can affect the value of their investments. Here, we look at how volatility affects investors at different stages of their lifecycle.
For retirees, in particular, it isn’t just the annual returns that matter – the order and timing of these returns can also be important. This is what we refer to as “sequencing risk”. Let’s take a closer look at sequencing risk and how the order of investment returns could have an influence on the value of one’s investment.
DOES THE ORDER OF RETURNS REALLY MATTER?
In reality, the order of investment returns doesn’t matter as much for many long-term investors. Because regardless of the ‘return path’ or order of returns, an investment will still have risen in value as long as the average return is positive over time. This is illustrated in Table 1, where Investor A and Investor B each invested $1,000,000 in different products.
Source: Colonial First State
As we can see, both investments delivered the same returns, but the order of those returns was reversed for the two investors. Investor A’s investment delivered two years of negative returns early in the period, while Investor B’s investment delivered negative returns at the end of the period. Assuming both investors stayed invested for the full 15 years, it is clear that the order of returns had no impact on their final investment balance – both investments grew to $1,284,863. This is because positive and negative market movements have averaged out over time. Importantly, despite the volatility in annual returns, the average return is positive.
For this reason, most people saving for their retirement should not be overly concerned about short-term volatility in markets, even though this can result in short-term downward movements in the value of their investment. Assuming that the long-term average return is positive, the value of their investment will grow.
SO, DOES ANYBODY NEED TO BE CONCERNED WITH VOLATILITY?
There is one group of investors, in particular, that may need to think about volatility and the order of investment returns – retirees. The following example illustrates how the order of returns can affect them. Let’s assume Investor C and Investor D are both 65 years old and about to retire. In order to help finance their dayto-day living costs, both investors will withdraw $5,000 each month, or $60,000 per year, from their investment.
Source: Colonial First State
Again, we can see that the two different investments delivered the same percentage returns, but that the ordering of the returns was reversed. The investment outcomes of Investor C and Investor D highlight how sequencing risk (or the order of investment returns) can be crucially important around retirement age. At this time, investors are typically making the transition from being savers to income-seekers – from building up their nest egg to drawing income from it.
If financial markets struggle around the time of retirement, there could be undesired consequences for the investor – such as delaying retirement to continue working, or having to reduce expenditure in retirement. This is the clear problem for Investor C. Regular withdrawals, combined with a series of negative investment returns in the first five years of retirement, meant that Investor C had less time to recover from negative market movements. In the above example, Investor C faced the unfortunate prospect of having their funds depleted less than 15 years into retirement. Over the same period, Investor D continued to accumulate wealth during retirement despite making exactly the same withdrawals as Investor C. This is because Investor D had the better fortune of having several consecutive years of positive returns early on in retirement.
WHAT CAN INVESTORS DO ABOUT SEQUENCING RISK?
The rapidly declining value of Investor C’s investment shows that sequencing risk can have serious implications for retirees. Importantly, it can make a meaningful difference to how long an investor’s savings will last in retirement and how much income can be withdrawn in order to help fund day-to-day living costs. As a result, sequencing risk must be addressed before investors reach retirement as part of a transition strategy.
One thing is for sure – volatility will remain a feature of financial markets. But while nobody can control the order of investment returns, there are some steps investors can take to mitigate the effects of sequencing risk.
HOW CAN INVESTORS MANAGE THE EFFECTS OF SEQUENCING RISK?
- Diversifying one’s investments across different asset classes could help to reduce the volatility of both investment returns and downward movements in individual asset classes over time.
- It may also help to review one’s asset allocation over time to reflect their life stage. For example, many investors with a longer time horizon to retirement may have higher exposure to growth assets like property and shares early in their working life, but may reinvest their funds into more defensive assets like cash or fixed interest as they approach retirement. It can help to learn about the different asset classes and how they fit into one’s risk profile.
- Consider adjusting one’s rate of savings over time, depending on an investor’s life stage and personal circumstances. At different times in an investor’s life, they may have different financial demands that determine how much they can contribute. For example, earlier in their working life, the investor might choose to have a higher contribution rate when income is typically lower to make use of compounding returns, and gradually reduce that rate as they age. However, as some approach retirement, they may instead consider maximising their contributions, which could potentially enable some tax savings. Again, it all depends on someone’s circumstances.
If you have any questions about sequencing risk, please speak with your Pinnacle Advisor.
Source: Colonial First State
