What Are The Risks In The Wrong Sequence Of Returns?

31/10/2013 by Dominique Schuh

Investing in any shares, fixed interest or real estate comes with the obvious risks of the fluctuations of those markets. At some time prices will fall and so will the value of your investment; this is a given as no investment consistently provides positive returns year on year.

However, an often forgotten risk factor is the order of your returns and whether you are adding money to your investment or withdrawing from it. This is known as sequencing risk and can play havoc with retirement expectations. Two investors can start out with $100,000 and over 30 years' time arrive at final balance of $600,000, but the sequence of returns that led them to that point may be very different.

Investor A may start off with a sequence of negative returns, severely decreasing their investment balance, while Investor B starts with a sequence of positive returns, significantly increasing their balance. Nearing retirement there may be a large difference between those investment balances, but consecutive positive returns for Investor A would grow their investment considerably. Similarly, consecutive negative returns will shrink Investor B's investment substantially.

The average rate of return across those 30 years may be exactly the same for both investors and they still retire with $600,000, but retirement expectations for Investor B would be given a jolt. Sequencing risk suggests the lowest return is more preferable when you have the smallest account balance and the best return when you have the highest account balance. The sequence of returns is also a significant factor when adding or drawing from an investment.

You inevitably do better if you add after a bad year and draw after a good year.

Avoiding sequencing risk comes back to the old favourite diversification; lessening volatility and maintaining emergency cash levels to draw from.

Adjusting asset allocation when approaching retirement can protect gains, but an investor will still need to be mindful of their longevity before totally abandoning risk assets. If you would like to talk more about this or any investment related issue, please contact Dominique Schuh on 07 5480 4877 or dominique.schuh@schuhgroup.com.au