Sequencing Risk

This month we discuss the often overlooked issue of sequencing risk within investment portfolio management.

Sequencing Risk

Sequencing risk is the risk of receiving the worst returns in their worst order.  Conventional wisdom assumes that retirees and those relying on investment income are solely affected by sequencing risk.   However, sequencing risk also affects wealth accumulators as they continuously and frequently contribute capital after the initial investment has been made.  The idea of sequencing risk contrasts with the principle that time in the market heals all wounds.   

Illustration of Sequencing Risk

Consider a 25 year old individual who commenced working in 2012 and intends to retire at age 65 (1 January 2052).  The individual has a starting salary of $41,552, salary growth rate of 4% and superannuation contribution of 9% p.a.  The graph below shows the cumulative and annual contributions of the hypothetic individual over their working life.

Source: Basu, A., B. Doran and M. Drew (2012) Sequencing Risk: A Key Challenge to Sustainable Retirement Incomes, Finsia (Financial Services Institute of Australia), Sydney. 

Here, the green bars show the contribution for the particular year and the gold bar shows the cumulative account balance (retirement nest egg).  The graph above does not take into account investment performance.  To illustrate sequencing risk we will take a sample of investment returns over a 40 year period and apply it to the contributions in the figure above.  We will apply the annual returns that occurred between 1972 and 2011.  The table below illustrates that the individual’s retirement nest egg (terminal wealth) at the end of the 40 year period will be heavily affected by the order of returns.  The first column applies the 1972-2011 returns in the order that they actually occurred.  The second column applies the 1972-2011 returns in reverse order.  The third columns applies the 1972-2011 returns in order of worst returns occurring first.  The last column applies the 1972-2011 returns in order of best returns occurring first.

Source: Basu, A., B. Doran and M. Drew (2012) Sequencing Risk: A Key Challenge to Sustainable Retirement Incomes, Finsia (Financial Services Institute of Australia), Sydney. 

The last three rows illustrate the consequences of sequencing risks.  In all four scenarios, the average investment return (mean) and volatility of investment returns (standard deviation) over the 40 year period are identical; 12% and 15% respectively.  However, the retirement nest egg (terminal wealth) is vastly different depending on which order the returns occurred.  As can be seen, if the worst returns occurred first then the hypothetical individual would have a retirement nest egg of $17.4 million.  This compares with the retirement nest egg of $1.4 million if the best returns occurred first.  With superannuation, regular and unequal contributions are being made continuously over the investment period.  Therefore, as indicated by the ‘terminal wealth’, the order of returns is of great significance to an individual’s retirement nest egg.  The order of returns does not determine the terminal value of an investment portfolio where an individual makes a lump sum payment at the beginning of the investment period and makes no additional contributions.

Managing sequencing risk 

Sequencing risk is very difficult to mitigate nor is there a ‘one size fits all’ strategy that can be applied to every investor.  Having said this, over the next few months (through The Wealth Pipelines) we will be discussing various strategies that may be used to mitigate the effects of sequencing risk.