Like a lot of industries, financial planning is riddled with terminology that can leave a lay person struggling to understand.
Sequencing risk is one of those terms and I want to explain it here because if you’re about to move into retirement, or you’re already there, you should probably care about what it is and how it can affect you.
Sequencing risk refers to the impact on the value of an investment portfolio from the order (or sequence) in which investment returns occur.
Let’s think of it this way.
When we’re in the accumulation phase of building our superannuation, we’re adding to our portfolio.
In retirement, however, we move into a different phase called decumulation, wherein we draw down on our portfolio.
During accumulation, we monitor our portfolio, but we’re not so concerned by the day to day (or even annual) shifts in our portfolio’s value, knowing that despite market fluctuations, it will build slowly but surely over time.
However, as we approach and then reach retirement, decumulation begins, as we start to draw down, rather than add to our portfolio.
It’s when we start this decumulation phase that sequencing risk can occur unless we adjust our mindset and portfolio management.
If you invest too aggressively (for example, in shares and property), losses may occur from which your portfolio may not recover.
Invest too conservatively, say, with cash and fixed interest, the risk is the income you need will be insufficient, a completely realistic scenario in the current low interest rate environment.
Here’s what it looks like when we apply sequencing risk to a portfolio.
If at retirement your portfolio is worth $500k and you draw down 5 percent or $25k in the first year, it’s possible that during the same period, the market could fall by 5 percent, resulting in your portfolio reducing in value by 10 percent overall.
Put simply, by withdrawing funds during a downturn you have less money invested to participate in the eventual rebound that will occur in the market.
Conversely, if the market went up during the same period, your portfolio would be largely unaffected by the amount of funds on which you had drawn.
So what can you do about it?
It’s one thing understanding sequencing risk, but it’s another doing something about it, right?
The good news is there is something you can do about managing sequencing risk at this pivotal stage of your financial life.
It’s what we call outcomes based investing.
Outcomes based investing involves shifting away from the traditional risk profile based framework that is applied during the accumulation phase, i.e.g where clients are segregated in ‘risk boxes’.
In outcomes based investing, financial planning is steered towards a more goals based world of tailored investment portfolios.
What this means is the portfolio is managed towards a more precise set of income objectives, with asset selection focusing on the desired portfolio yield (income).
For example, by prudent ‘targeting’ of yield, using specific Australian shares with attractive tax benefits in the form of franking, infrastructure assets, or bonds with higher interest yields and an overall reduction in the risk parameters, investors can focus on the income they need.
If planned well, this yield should hold up, even in market downturns, thereby preventing the temptation to make ‘sell out’ decisions at the wrong times.
If you’re not close to retiring, you don’t need to do anything…yet. However, if you are on the cusp, or have already retired, you may need to adjust your mindset around the ongoing preservation of your portfolio post retirement.
The take-away here is: your retirement investment psychology needs to change, depending on what we want our portfolio to do.
I’ve mentioned in other blogs that as financial planners we are in people’s lives as they navigate big changes. Retirement is one of those phases where it pays to engage the advice and services of a licenced financial planner, rather than the opinion of a mate at a Saturday afternoon barbecue.
Working together, you can devise an approach to managing your retirement funds, and approach sequencing risk, without your money drying up due to bad timing.
Approaching your retirement portfolio management this way – by engaging someone who’s unemotional and unattached – can make the difference to adding or taking away value where it counts: in your retirement.
Are you approaching retirement or have you already retired? Have you adjusted your approach to your portfolio’s management? How is that working for you.
Please share your experiences in the comments below.
“This document or website contains general advice only. You need to consider with your financial planner, your investment objectives, financial situation and your particular needs prior to making an investment decision. Charter Financial Planning Limited and its authorised representatives do not accept any liability for any errors or omissions of information supplied in this document except for liability under statute which cannot be excluded.”