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VIEWPOINT: DOES SEQUENCE RISK MATTER?

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The hard part of investing is discipline, patience and judgment. Investors need discipline to avoid the many unattractive pitches that are thrown [their way], patience to wait for the right pitch, and judgment to know when it is time to swing,’ says Seth Klarman, billionaire investor.

Traditional financial planning is linear in nature, based on projections of steady market performance, regular monthly withdrawals, and stable inflation. Yet the real world isn’t like that: the ride is bumpy.

Another equally important investment risk is not taking risk, or ‘reckless conservatism’. Approaching retirement and thereafter, you will often find yourself being advised to invest very conservatively. However, if your portfolio is not at least beating inflation, it will effectively shrink each year with devastating consequences on retirement income in real terms.

You probably understand the need to control your own negative investment behaviours which result in your personal return not matching that of the market. However, failure can equally come from simply doing nothing. In environments of low growth, market volatility or negative returns, what is the effect of sequence risk?

Falling markets

Sequence risk is defined as ‘the risk of receiving lower or negative returns early in a period when withdrawals are made from an individual’s underlying investments’. This means you can start saving with exactly the same amount of wealth, enjoy exactly the same investment return over the period, but end up with significantly less in different scenarios. For example, a 10% drop in the market early on could mean that a 5% planned drawdown rate increases by necessity to 5,5% to meet your needs, resulting in a drop in real-income growth from 19 to 17 years, and the success rate from 54% to 44%.

This is key for retirees living off the income of their capital investments. The returns earned during the first few years can have a major impact on their wealth in the long run. A pragmatic rule of thumb in retirement planning is to withdraw about 4% a year from the portfolio. However, the reality is that retirees need a fixed sum – like drawing a regular salary – and often also make intermittent lump sum capital withdrawals (such as for that overseas trip).

If one retires during the bottom of a bear market, though performance will generally improve and capital values grow, the relatively high percentage of front-ended withdrawals against the portfolio may reduce the retirement period and capital in the end. Remember, a 50% drop in the value of a portfolio requires 100% growth to recover.

Where portfolio values are relatively high at retirement date, the relative percentage of a withdrawal would be lower, leaving more in the portfolio to generate future returns in retirement.

My top tips

  • Consider investments that create income in your portfolio.
  • Consider investments where capital preservation is key if these are your retirement funds and you cannot afford losses.
  • Consider guaranteed products, though these come at a cost.
  • Structure and differentiate investments to deal with short-, medium- and long-term investment objectives while protecting against volatility in the markets.
  • Reduce monthly withdrawals by cutting or deferring expenditure.
  • Defer capital purchases.
  • Defer retirement or phase it in.
  • Get professional financial advice and go for your annual review as one would do with any annual ‘health check’.
  • Remember, the environment and your own circumstances are ever-changing.

Author: Mike Lledo CA(SA) is New Business Initiative at Citadel Wealth Management