Wednesday, November 7, 2012

What if I get the worst run of returns in the worst order?

When we invest in markets, we know to expect volatility.  We also know that diversification and a long term timeframe will help to manage this volatility and give us a reward for the risk we take.
A further sub-set of this general market risk that many investors do not know about or address is sequencing risk.
Put simply, a father of 60 and son of 30, choosing the same assets for their superannuation portfolio and both measuring their average return at 8%pa over a 20 year period, will likely have very different investment experiences, due to sequencing risk.
To start in understanding this issue, consider these points:
  1. When you experience a 10% loss in one year, followed by a 10% increase the year after - you are not equal.  It takes a higher rate of return to recover from a downward turn.
  2. Secondly, losing 10% on a $10,000 portfolio (when you're young and uninterested in retirement) has much less impact than losing 10% on a $1 million dollar portfolio, 2 years out from retirement.  This is known as the "portfolio size effect".
  3. Finally, we have to acknowledge that you regularly add to your super portfolio over time and there will be regular income you want to withdraw from your account one you retire.  These inflows and more importantly, when they occur - have an impact.
To highlight this issue, let's look at 25 years of hypothetical returns and re-arrange those annual returns to occur in 3 different orders.
If you were 40, saving for retirement over this 25 year period - your retirement savings bucket would vary considerably depending on the order in which you experienced the returns, as seen below:

Similarly if you were aged 65 and about to retire, your retirement bucket would last for vastly different timeframes depending on the order of returns you experienced.

Hence we are faced with a challenge.  We know that the majority of Australians do not have enough capital or money in their super bucket to park it in cash and live off the interest.  We know that having some exposure to growth assets will be necessary to ensure our funds last, but what if we get the worst run of returns in the worst order?

New rankings published by Mercer on October 15, 2012 suggest that Australian super funds have the highest share of their holdings invested in growth assets in the world.  So this suggests that we may feel the brunt of sequencing risk more than other countries.

Sequencing risk can be addressed in a strategic way that accounts for the possibility of negative returns in the last stage of accumulating your wealth (pre-retirement) or early stages of retirement.

Milevsky & Salisbury (2006) suggest that there is a retirement zone.  So if you're 40 now and plan to retire at 60 and we assume that you will live until you're 90, between the ages of 50 and 70 you could be taking a strategic approach to your asset allocation to tackle the impact of sequencing risk.  You may be relying on your super fund trustee to get this right for you, but we warn that a "default" asset allocation that you haven't chosen to suit your personal needs and objectives could be very risky.

The Association of Super Funds of Australia (ASFA) recently published this average asset allocation of "default" strategies which is between 56-70% invested in volatile, market-linked assets.

Outside of the family home, the next largest pool of assets is typically capital accumulated for your retirement.  Based on the impact sequencing risk can have, perhaps it's worthwhile having a trusted adviser show you ways to manage this.

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