Sequencing risk is one of the most important things to consider when constructing your investment portfolio.
Sequencing risk refers to the order in which investment returns occur and the impact they can have on portfolio returns. Sequencing risk has the largest impact when an investment portfolio is subject to both market volatility and cash flow drawdowns, such as in retirement portfolios. Failure to future-proof a retirement portfolio against sequencing risk can be disastrous as it could result in you not having as much money as you expected in your retirement.There are several ways to protect portfolios against sequencing risk:
- Traditionally, most investors are advised to reduce the risk level of their portfolio in order to mitigate against sequencing risk. i.e. become more conservative investors to reduce overall risk. While this advice is not necessarily incorrect, it is not always appropriate for all types of investors. For example, investors that may be concerned about longevity risk, or those that are well-funded and are comfortable taking risk to generate higher returns to help build a legacy for future generations. So, while reducing the risk profile may help reduce sequencing risk, it may involve unnecessary or unwanted trade-offs.
- Another common strategy to address volatility is to try to create a well-diversified and highly uncorrelated portfolio. This may be a somewhat effective strategy to prevent sequencing risk without necessarily sacrificing returns; however, care must be taken as this strategy may not always work out as planned. O’Sullivan (2013) argues that previously uncorrelated assets can perform similarly during market stress, as we have seen during recent market dislocations.
- A third and simpler method to implement is using the ‘bucket’ approach to investing. Pioneered by Harold Evensky in 1985, this approach divides your portfolio into different ‘buckets’ with each bucket serving a different role (Mace 2020). A practical example of the ‘bucket’ approach is the three-bucket retirement strategy wherein your portfolio is divided into short-term, medium-term and long-term goals. The short-term bucket is designed to meet your near-term living expenses for a certain number of years. The second bucket is a ‘medium-term’ bucket that provides a middle ground of less risky assets to produce income and / or be used to refill the short-term bucket as they are drawn down. Lastly, a long-term bucket is designed to help either manage risk or grow the capital to help address your longevity needs or risk tolerance.
Note: This approach is also commonly referred to as Goals Based Investing, with each of the different buckets set-up to achieve different goals or outcomes. (For more on Goals Based Investing you can refer to article What is Goals Based Investing)
When researching the academic literature and thinking it through, it seems a strategic application of the bucket approach together with the use of the goals based investment approach provides a more rational approach to reduce sequencing risk in a way easy to understand and monitor.
But, while very effective and easy to implement at the strategic level, goals based portfolios require more dynamic investment management to help manage risk and deliver better outcomes through the cycle. Generally speaking they have a much broader asset allocation range and investment selection than investing in traditional risk profile portfolios, which are generally more static through the cycle, regardless of the outlook. This provides the portfolio with greater flexibility and diversification to navigate an ever-changing world and avoid the pitfalls.
Luckily, there is a better way.
References
- Davis W, O’Connor A 2019, ‘Longevity and sequencing risk’
- Mace J 2020, ‘Is a bucket strategy the solution for your retirement income plan?’
- O’Sullivan K, 2013, ‘Sequencing risk and ways to manage it’
