A KEY missing piece of the investment puzzle...
In my last piece, I explained how important risk-adjusted returns are in investment, as against returns alone. This is an idea that is poorly understood.
Today I wanted to explain another concept which is arguably even less well known and even more important for your ability to build wealth over time: Something called "sequence risk".
As you will hopefully see as you read on, this is one of the very most important ideas to understand if you want to succeed with investment. Amazingly, it is also an idea that is hardly ever contemplated or even discussed by most of the finance industry, which means that the vast majority of “normal” people will have no idea about it at all of course.
Long-term readers of these articles may remember that we are extremely fortunate to collaborate with two leading finance professors on our investment fund: Professors Andrew Clare (bio) and Steven Thomas (bio) of the Cass business school in London.
As a quick reminder of who they are:
Andrew is the Professor of Asset Management at Cass and the Associate Dean for Corporate Engagement. He was previously a Senior Research Manager in the Monetary Analysis wing of the Bank of England supporting the work of the Monetary Policy Committee (MPC) and the Financial Economist for Legal and General Investment Management (LGIM) prior to that. Andrew is co-author of “The Trustee Guide to Investment” and in a survey published in 2007, was ranked as the world's ninth most prolific finance author of the past fifty years. He serves on the investment committees of corporate pension schemes worth several billion pounds.
Steve is Professor of Finance at Cass and Associate Dean of their MBA programme. He is a member of the editorial board of the Journal of Business Finance and Accounting and in a 2006 review was ranked 11th in Europe for finance research. Since 1988, he has been consulting editor of a range of credit publications for the FT and Interactive Data. Steve is also an examiner for the Investment Management Certificate of the CFA UK and author of the accompanying Official Training Manual - that is to say that he is one of the people who sets the exams for a decent chunk of the UK finance industry!
Back in March of this year, Andrew and Steve were kind enough to contribute a guest-article about our fund.
I am grateful for their help again today in our attempt to explain the vital importance of “sequence risk” for your money. So here goes:
Sequence risk is the idea that the order of your returns matters more than total returns and even the volatility of returns (that I discussed in my my last article), when it comes to building wealth in the real world.
This may sound a bit complicated, but it really is sufficiently important to merit an attempt to explain as best we can in “plain English”.
“Accumulation” versus “decumulation”
In the real-world, there are two investment phases in your life:
- "Accumulation": The period in which you attempt to build wealth by saving and investing. We might think about this being your focus from roughly the age of, say, 30 to the age of 60.
- “Decumulation”: The period in your life when you will want to live on the wealth you have built in the accumulation phase. We might think about this as, say, roughly from the age of 60 to the age of 90 (with apologies to anyone over the age of 90 who might be reading this!).
The crucial point we are trying to make here – is that in both of these phases, the ORDER in which you make returns is more important for real-life outcomes than the SIZE or VOLATILITY of those returns.
This idea is so unusual in investment thinking that it requires a couple of simple numerical examples to illustrate.
Accumulation: The importance of ORDER “on the way up”:
Let us take the example of a thirty-year-old who has managed to save £10,000 in their 20s. Let us also assume they are able to save and invest £500 a month into a stocks and shares ISA account.
(The concept is easier to illustrate and comes across more powerfully with bigger numbers, so please forgive us if this seems like quite a punchy savings assumption! I appreciate that someone will need to be on a pretty decent income in order to be able to invest £500 a month. The point is just as valid with much lower numbers but doesn’t “pop” quite as much as what follows. I might also point out that £500 a month should be a number that many couples can aspire to save together – i.e. perhaps around £250 a month each).
Next, let us assume they are able to make roughly equity market returns from the age of 30 to the age of 60. We will therefore assume 7.5% per annum. So – they are starting with £10,000, saving £6,000 a year and making 7.5% returns.
Now comes the really interesting bit – let us assume that one year in those 30 years, they suffer a big stock market crash. The S&P 500 fell 38% in 2008, so we are going to use that number for the purposes of illustration.
The table below shows you how this person will build real wealth, given the assumptions we have made, but illustrates the significant difference that results from the ORDER in which those returns happen. I have highlighted the impact of that 38% down year in red in each of four scenarios: Whether they have suffered the big loss at the age of 30, 39, 49 or 59. The fifth scenario (on the right column) shows their progress if they don’t suffer that big 38% loss in any year.
You can see that if they have that massive -38% crash year when they are 31, they end up with a pot of £670,890. If, however, they are unlucky enough to experience that massive fall at the age of 59, they end up with £410,843. This is a £260,000 difference. The person who endures a big stock market crash the year before they retire will be nearly 40% worse off than someone who suffered it as they were just getting started on their investment journey. Of course, they will be even better off if they manage to avoid having a big down year at any point on the journey and will end up with even more (right most column).
…all of these scenarios have the same overall AVERAGE percentage returns and VOLATILITY – because the person averages 7.5% for 29 years and has one -38% year. But there is a very significant difference in their actual, real-world outcome as you can see…
That right there is sequence risk. It is actually just a simple function of how the maths work – and “the break even fallacy” in particular (which I explained in my last article if you want a reminder).
In my experience, this reality is seldom, if ever addressed by fund managers or by the financial press. It is THE most important investment concept which almost no-one understands or takes account of in their thinking.
(As a quick aside: The existence of the phenomenon illustrated above was the main reason I took the time to write my new book earlier this year and to explain the crucial idea of “100 minus your age” when it comes to allocating capital to “aggressive” versus “defensive” assets)…
Decumulation: What about on “the way DOWN”?
So, we have seen the enormous variation in your likely real-world experience caused by sequence risk “on the way up”. Now let us consider the same concept with respect to what may happen in retirement.
We are now looking at someone’s real-world experience from age 60 to 90. Let us assume that they managed to have built an investment pot of £500,000 by the time they turn 60 (something we firmly believe is entirely possible for anyone who starts their investment journey early enough and invests sensibly by the way – as you can see from the example above. This is also a case I made in my first book).
Let us also assume that they have paid off their mortgage and can live reasonably well on, say, £25,000 a year – so will want to take this amount out of their pot each year (they will “withdraw” £25,000 a year). We will keep the average annual return and “terrible crash year” assumptions the same at 7.5% and -38%.
(For the avoidance of doubt - we acknowledge fully that these are not “realistic” numbers – no asset is going to give you a smooth 7.5% every year for 29 years with only one big down year – but all we are trying to do here is show the very significant real world impact of sequence risk in the most compelling way possible so that the point really comes home. Huge differences will also occur with more “realistic” numbers, as we hope should be clear).
Above, you can see the crucial difference in the ORDER of returns in retirement. In the above scenario, if someone is unlucky enough to experience a big crash year when they have just retired – they will then run out of money before they turn 85 (left hand column).
In contrast, if the crash doesn’t happen until they are 80, they will still have £782,897 by the time they turn 90 – what a difference! And if they never suffer a big crash year at all, amazingly enough they will power into their nineties with more than £1.5 million!
Again – it is important to stress that ALL of these scenarios have the same overall AVERAGE percentage returns and VOLATILITY – but there is a very significant difference in the real-world impact on the individual’s wealth (as you can see!).
Each column is the same in terms of return and ‘risk’ (other than the right hand most one, as it does not have a big down year), but there is a different order of returns!
This is pretty crazy when you think about it really, and a tragedy just how few people understand this stuff… (I would argue that this is yet another key reason for pensions crises the world over but this is a subject for another day)…
So, what to do?
So how do we go about increasing our chances of beating this awful “sequence risk”, given how robustly negative it can be for our ability to survive and thrive financially over time?
In the Professors’ own words:
"Well if we can see the future we can move into cash or short-term bonds just ahead of when the stock market crashes…?! Good luck with that one!
Or, we can buy derivatives such as put options which pay off when the crash comes…
No surprise here that the price of such protection exceeds the benefits on average, otherwise the investment banks selling those derivatives would go bust!
We have researched and published extensively on the role of switching to cash temporarily when certain price signals indicate a fall in an asset price is underway. We call this “smoothing” asset returns and there is a well-trodden investment research literature on this.
This literature explores many asset classes, periods of history, and various countries, and there is a generally unanimous finding that this “trend-following” approach is a successful strategy in the long run.
So why doesn’t everyone do it?
Firstly, many investors chase high returns and time their entry and exit from investments following gut instinct, news flow and investment fads and fashions. Basically, we all suffer from powerful “behavioural biases” that make us worse investors.
We need an investment rule to overcome these biases.
This includes “patience”, as the strategy of switching into cash to protect the downside will at times lead to underperformance. But the evidence shows that the tortoise will still very likely “win the race” over a lifetime of investment. Remember that it only takes one large down year to undo many previous years of investing “like a genius.”
Secondly, of course, there are many vested interests in promoting other ideas, as in any business context. In the main, investment companies the world over will likely make a great deal more money selling far less boring strategies than this one.
Whatever the reason, the KEY thing to remember here is this:
Whether you are still accumulating (saving) or decumulating (drawing a pension), you should see Sequence Risk as your enemy number 1!
If you were to experience a big loss just before the end of accumulation and / or at the start of retirement, you would lose the benefit of a large chunk of your contributions plus investment growth at exactly the very worst time.
…and your retirement withdrawal possibilities would suffer dramatically as a result.
That is why reducing the possibility of EVER suffering any large losses is possibly THE most important of all sources of risk - for the saver and for the retiree alike - but is heavily neglected by the finance industry!
Why, you may ask? Perhaps because there is no statistic or measure that easily summarises this aspect of investing (although we have recently explored the ideas in an article for the Journal of Retirement). There is currently no “league table” for master of the universe fund managers to compare each other based on their ability to deal with sequence risk.
This does not change the fact that reducing the possibility of big drawdowns is arguably THE key ingredient in devising successful long run investing strategies…”
I hope the above has been useful in explaining such a key investment concept and one that is much neglected. As ever, if you have any questions, thoughts or comments, please don’t hesitate to get in touch.
More generally, if you think you might need a bit more hand holding to really get to grips with this stuff, please do consider joining our online community.
…and, of course, if you haven’t already, please do check out our investment fund which seeks to deliver the long-run investment outcome we have presented above in the right hand most columns of both tables - by making downside protection the number one focus.