You’ve likely heard the old refrain - “investments rise and fall over time”. Yet, few people grasp the importance of when these movements occur. In particular, what happens if the market falls just as you are about to retire and draw an income from your investments (e.g. pensions)?
This concept is known as sequencing risk, and it can have a significant impact on your returns and goals. Below, our team of financial advisers offer a short guide to sequencing risk - what it is, how it works and ways to navigate it effectively.
Similar to inflation, sequencing risk has hidden (yet critical) effects on your portfolio. It all boils down to timing - i.e. the danger of experiencing falling returns as you are regularly withdrawing from your portfolio.
This is especially important when people are looking to retire. This is because most start to alter their financial strategy from wealth accumulation (growing their portfolio) to decumulation (taking a regular income from their portfolio whilst preserving it as much as possible).
Imagine you are just about to retire and you start making withdrawals. If the market is rising (i.e. there is a “bull market”), the money you take out is partly offset by the returns you are making. However, the reverse is also true.
If there is a “bear market” and you are making withdrawals, the balance is not offset via new deposits (e.g. dividends reinvested into your portfolio). If this is sustained, the pot will gradually shrink as you maintain the same cash withdrawal amounts.
Over long periods, sequencing risk can alter an individual’s wealth growth by six figures or even more. For instance, suppose someone has £10,000 saved already and starts saving £500 per month. Over 30 years, they achieve a 7.5% average yearly return. However, a time comes when the market crashes by 38%.
The timing of the crash will dramatically affect this person’s wealth trajectory. Imagine it happens on their 31st birthday. Here, the individual’s portfolio could be worth approximately £671,000 in thirty years’ time. However, if the market crashes by 38% at age 59 (just before they retire), then their portfolio could fall to about £411,000.
Sequencing risk has a varying relationship with different types of assets (e.g. equities, bonds and cash). For instance, equities are typically more volatile. Whilst they can offer higher returns than bonds and cash, they could also heighten your sequencing risk just before retirement.
Bonds, by contrast, are less volatile than equities on a one-year basis. So, financial advisers may recommend them to investors as they enter the decumulation phase, to help preserve their portfolio as they start making withdrawals to fund retirement.
However, bonds are sensitive to changes in interest rates. If a rise occurs, your bond holdings could be negatively affected. Cash can be a viable asset for stabilising a portfolio. However, it also produces lower returns, which typically do not match inflation (resulting in real-terms losses over time).
You cannot control the markets. However, you can mitigate sequencing risk using a wide range of strategies. Here are some examples, although their suitability will depend on your unique financial goals, needs and situation:
Sequencing risk is a crucial yet little-understood part of investing and retirement planning. Here at Castlegate, our team is here to help you navigate it with prudence and confidence - armed with the best possible information regarding your portfolio.
If you’d like to make sure you’re taking the right steps to safeguard your financial future, please get in touch.
Your capital is at risk. Investments can go down as well as up, and you may get back less than you originally invested. Past performance is not a reliable indicator of future results. Pension investments can go down as well as up, and pension access is normally at age 55 (rising to 57 in 2028). The value of any tax benefits depends on your individual circumstances and may change in the future. No guarantees are given on projected outcomes, and diversification does not guarantee returns or eliminate the risk of loss. This content is for information purposes only and does not constitute personal financial advice. You should seek independent financial advice before making any investment or retirement decisions.
Castlegate Financial Management Limited is registered in England No. 2077374. Registered Office: 8 Castlegate, Grantham, Lincolnshire. NG31 6SE. Authorised and Regulated by the Financial Conduct Authority. FCA No. 169777.
