Investors who are planning for retirement or in a period where they are starting to make retirement plans are faced with myriad choices as to capital allocations. While some other opinion pieces on this website address the crucial differences between “growth assets” and “income assets”, it is worth a small recap.
Property and shares are growth assets and are attractive to investors who are still in or close to their prime years of salary or income generation. Losses in capital on such investment may be able to be replaced. Most advice would be to increase allocations as retirement approaches as our ability to replace capital lost is reduced or, at worst, non-existent.
As individuals reach the period where they are making net withdrawals from their pool of assets, which they have worked a lifetime to accumulate, capital allocation becomes key.
Why does this matter to me?
While investors should always be worried about excessive volatility in “risk” markets such as the share market, it is important to understand that the timing of the “down” years is very important.
Sequencing risk is the danger that the timing of withdrawals from a retirement account will have a negative impact on the overall rate of return available to the investor. This can have a significant impact on a retiree who depends on the income from a lifetime of investing and is no longer contributing new capital that could offset losses.
Example:
Sequencing risk has less of an impact on the safest retirement investments like U.S. Treasury bonds, which generate predictable if unspectacular rates of return. It has a greater effect on any investment that can go up and down over time, from stocks to gold to real estate.
One of the basic rules of investing is that a long-term strategy is self-correcting. Keep investing a steady amount of money month after month and year after year and the average return should be solid.
The below example shows how wrong this can be if there are steady capital withdrawals; and how the differences are magnified if the bigger up and down years occur at the beginning of a drawdown period. See below:
For both Ron and Maureen, the returns in their first 10 years of retirement are an average of 4.5%. Fortunately for Ron his first two years are plusses whereas Maureen’s are negative and the cumulative effect as they draw income is a difference in available funds of ~$100k, or about 23.5%.
Reducing sequencing risk
While the above returns average 4.5% for both investors, they fluctuate quite markedly. Each investor is very advantaged or very disadvantaged by the timing and volatility of these returns.
Consider the unlikely event above where Ian achieves not only an average of 4.5% annually, but in this case the returns are identical at exactly 4.5% annually. In this case he ends up in virtually the same position as Ron and ~$100k better off than Maureen.
Clearly, these are for illustrative purposes, but we can see that less volatility is a very much better result for an investor in drawdown phase than wild fluctuations.
What should investors do?
Portfolios with shares and a meaningful percentage in bonds will have more stability, meaning those leading into retirement age can potentially make a meaningful difference to their prosperity by including fixed income assets and reducing the volatility of their investments.
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