Reducing “bad luck” in retirement investing
A little-considered, but significant, risk when investing for retirement is “sequence of return risk” or “sequence risk”. This is when an investor ends up with less capital than expected at retirement, but has actually done everything right: made regular, sufficient investments for the prescribed number of years, stayed invested in the right assets, and even earned the correct targeted average return over time. How is this possible? Simply because they were unlucky: the sequence of investment returns they received, following the ups and downs of markets over time, ended up being unfavourable for them.
Take the example of two investors as shown in the graph, Joe and Jane. All of their investment parameters are identical, including their average investment return over 40 years. However, because Joe started investing three years earlier than Jane, the sequence of their annual returns ended up markedly different: their returns accumulated in different ways as the markets, and their capital, gained and lost value over the years, so that Joe ended up with some R1.5 million less at retirement than Jane. It was simply a matter of unlucky timing for Joe.
Financial advisers and investors have no idea who will end up being unlucky when they start on their investment journey, since no one knows when market downturns will happen. Therefore everyone needs to incorporate some techniques for reducing sequence risk in their retirement planning. One of the primary ways is to build a well-diversified portfolio with enough growth assets (equities, property) to meet your longer-term goal, while also including income assets (bonds, cash) to cushion the market downturns. Such a balanced portfolio can reduce both the volatility of returns and the severity of negative return periods, without significantly impacting total returns earned.
Active asset management is also very important, since the manager can underweight asset classes that are overvalued in order to mitigate future losses in market downturns, and overweight undervalued assets where necessary. Thirdly, a valuation-sensitive approach to both stock selection and asset allocation can also help: historic performance data shows that buying assets at undervalued levels (compared to their history) increases the probability of enhanced future returns. And finally, some active fund managers like Prudential also design their funds to help compensate for market downturns, managing them to meet a longer-term return objective like retirement with a very risk-conscious approach.
By implication, retirement solutions that employ a passive or fixed long-term asset allocation, and ignore asset valuations, can exacerbate sequence risk. The same can be said of target-date funds that have pre-determined paths that simply reduce equity weights as retirement approaches, without taking cognisance of the valuation of those assets at the time. Such methods can force investors into undesirable portfolio exposure, for example, by obliging them to sell equities when they are cheap. They focus on solving the wrong problem – high market volatility – when the true concern is falling short of your retirement goal.