Sequencing risk and the effects on investors
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Ever wondered about the word average?
We hear and see this word almost daily. The average Australian is 37 years old. The average Australian pays 13.29% of tax each year. The average rainfall in Adelaide is 520mm per year. The average number of children per family in Australia is 1.8.
More often than not the average doesn’t apply and we simply fall above or below. Defining the average is useful to better understand the relativeness of things but can be dangerous if it’s being used as or assumed to be the norm.
The average annualised ASX200 investment return over 10 years to June 2021, is 9.3% yet, in no single year was the return 9.3%. An investor either did better or worse than the average in every year. If an investor happened to make a single contribution investment on day one of the period, they would achieve the average of 9.3% for the amount invested but may have had long periods of significant over or under performance for the rest of their invested monies. This brings us to the topic of sequencing risk.
What is sequencing risk?
Sequencing risk refers to the order in which investment returns occur and how it can impact investment cash flow. While sequencing risk is present in accumulation phase, its impact is greatest in the years either side of retirement. Having five or six years of very poor performance when you need to live off the capital, followed by better returns only later in life doesn’t help when you have depleted much of your savings.
No-one can consistently get timing right so we’re not going to pretend that we, or anyone else can. Cycles and uncertainty are a reality and we need to understand and manage the associated risks. We all naturally aspire to end up with the above average number but the road is hard and bumpy.
How does sequencing risk impact investors?
Let’s use case studies to paint two sides of the picture.
Meet Leanne and Warren. They retired in October 2007 and invested all of their savings in the ASX200.
Markets fell sharply with the global financial crisis and they had to wait until October 2013 (six years) to recover their investment capital (getting back to 0%).
The good news is that since October 2013 (past 8.5 years), they enjoyed a wonderful 94% total investment returns.
The catch: they withdrew 6% pension per year from their superannuation in this first six year period. When the market recovered and returned 94%, they only had 64% of their original capital left to participate in the recovery and lost out on more than a third of future returns.
Life continued while they waited for better returns and they had to pay for if somehow.
Meet Leanne and Warren’s daughter, Samira. She made regular contributions to her superannuation portfolio from 2007 to 2013 which meant she had significantly more capital to participate in the good years that followed.
Can sequencing risk be managed?
Having a strategy to manage sequencing risk is better than nothing. While no strategy will mitigate the risk entirely, there is the opportunity to limit the fallout.
If retirement has not yet happened, potentially the choice can be made to work a little longer and continue to add to savings.
If investors are already retired:
- Could regular pension payments and lifestyle expenses be reduced temporarily and big lifestyle expenses postponed to keep more invested for longer?
- Can investment portfolio be modified to focus more income producing investments to avoid or limit selling down?
- Can enough cash be set aside to meet short-term requirements to reduce the need to sell down investments to provide liquidity?
At Hood Sweeney Securities we are passionate about helping our clients on their financial life journey. Whether sequencing risk needs to be considered for retirement or, capitalised on in accumulation phase, we craft a strategy that aims to achieve better outcomes for your financial circumstances and needs.