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It’s not fair! Sequence of returns risk

You never know what return the wheel of fortune will deliver each year

With the mindset of a long-term investor, you avoid a lot of the worries that afflict the frightened hordes.

You’re not scared out by a stock market crash. Nor do you pile in at the top.

Instead you develop the tough-under-fire attitude of a Vietnam veteran on his third tour of duty. When share prices plummet you go surfing, Apocalypse Now-style, while others quiver before CNBC.

“Is that all you’ve got?” you laugh as the stock market falls 10%.

The average after-inflation annual return from shares globally is 5% per year1. So as long as you sit tight and keep the faith, you’ll eventually be rewarded, right?

Well… yes, probably…2

The sequence of returns matters

You’d better know that there’s another kind of risk you need to think about, and it’s potentially nasty.

It’s this: The return you get in your investing career might be different to the return I get – even if we both enjoy the same average 5% real return over three decades on our investments!

Huh?

I know – it’s counter-intuitive.

It also has a clumsy name. It’s called the sequence of returns risk.

The sequence of returns risk is essentially the risk that fate will deal you a shocking hand – that the timing of bear markets and bull markets will fall less favourably for you than it does for another investor.

It’s why we’re urged to reduce our exposure to the riskiest assets as we approach retirement age.

It’s also why a decade of steep stock market falls could bode well for younger investors who have saved throughout the turmoil.

The best time to get bad hands when you’re regularly putting money into shares is when you’re starting out – because you learn your lessons early, and you’ve got less money to lose.

In contrast, the last thing you would want the day before you retire is to have all your lifetime savings in shares, only for the market to get sliced in half.

How to multiply your money

You might not think it matters what order the market tosses up its treats and its treacherous years.

Returns from investment are multiplicative – you multiply your money!

And every precocious child knows that it doesn’t matter what order you multiply numbers together. You still get the same result.

For example:

1 x 2 x 3 x 4 = 24

4 x 3 x 2 x 1 = 24

3 x 4 x 1 x 2 = 24

It’s exactly the same with investing.

When the market delivers a 20% return, it goes up 1.2 times.

When the market falls 10%, you multiply it by 0.9 times.

1.2 x 0.9 = 1.08

0.9 x 1.2 = 1.08

So why does it matter to us poor strivers exactly when the sturm und drang of a stock market crash hits us?

Well it wouldn’t if you were a member of the landed aristocracy and you were just managing a big pile of loot before passing it onto the next generation (after six or seven decades of compounding and an unsavoury sex scandal or two).

But most of us are investing new money over our lifetimes to ensure our financial futures – and we also have to withdraw our savings in retirement.

And it’s because we add and subtract money from the market over time that the sequence of returns risk can have its wicked way with us.

Here’s one we did earlier

Let’s consider a real world example. Here are the total returns from the FTSE 100 for the five years from 2008 to 2012:

Year Return
2008 -28.3%
2009 27.3%
2010 12.6%
2011 -2.2%
2012 10.0%

Source: FTSE

Do the sums and you’ll see that’s an average annual return of 3.9% per year.

Now let’s imagine you had invested £100 at the start of 2008. Here’s where your money would have stood at the end of each year:

 Year Return Investment
2008 -28.3% £71.70
2009 27.3% £91.27
2010 12.6% £102.77
2011 -2.2% £100.51
2012 10.0% £110.56

Note: £100 compounded for five years, as per the returns listed.

The first thing to note is that you’ve ended up with less than you might have expected from the 3.9% average annual return.

Plug 3.9% into a compound interest calculator and you’ll see you might have anticipated £121. You got £10 less.

This is because investment returns are geometric, rather than arithmetic. But that’s another article…

Investing in Bizarro World

Getting back to the sequence of returns, let’s imagine you fell through a wormhole and ended up in an alternative reality, and five years in the past.

(Stay with me here!)

Being a good saver, you shrug off your trip through space and time and make your way to the nearest stockbroker. People still need to save and invest for their retirement it turns out, even in this Bizarro World.

But things aren’t entirely the same.

In this alternative reality, the annual returns you get over the five years from 2008 to 2012 are reversed as follows:

Year Return
2008 10%
2009 -2.2%
2010 12.6%
2011 27.3%
2012 -28.3%

Source: Bizarro World Bank Headquarters broom closet.

This time the big crash comes at the end of the five-year sequence, rather than at the start as it did for us in our reality.

Do the maths and you’ll see you get the same average 3.9% return.

But what about your £100 investment?

Year Return Investment
2008 10.0% £110.00
2009 -2.2% £107.58
2010 12.6% £121.14
2011 27.3% £154.20
2012 -28.3% £110.56

Note: £100 compounded for five years on Bizarro World.

As we expected, because returns are multiplicative, we end up with exactly the same £110.56 in Bizarro World as we got on Planet Earth – even though the sequence of returns is reversed.

So far so good!

Adding up the cost of bad luck

The complication comes if you are saving or taking money from your investment over the years.

Let’s say you add £20 at the end of each year to your ongoing investment.

In our reality on Planet Earth, this would have played out as follows:

Year Return Investment
2008 -28.3% £91.70
2009 27.3% £136.73
2010 12.6% £173.96
2011 -2.2% £190.14
2012 10.0% £229.15

Note: £100 initially invested, then £20 added at the end of each year.

What about in the alternate reality, where the sequence of returns was reversed?

Here you’d end up with a different result:

Year Return Investment
2008 10.0% £130.00
2009 -2.2% £147.14
2010 12.6% £185.68
2011 27.3% £256.37
2012 -28.3% £203.82

Note: Again, £100 in, then £20 added each year. Alternative return sequence.

As you can see, falling through the trouser leg of time3 has reduced your final sum by around 10%.

Now I don’t know how much things cost in Bizarro World, but I’m sure you’d rather have that extra spending money.

More seriously, this is exactly what happens in real life to different investors with slightly different saving schedules. The sequence of returns varies over time, and so two regular savers with the same general strategy but investing over different periods will see different sums accumulated by the end, even if they enjoy the same average annual return.

People who retired in the late 1990s as the stock market soared were laughing.

People who retired in 2003 after several steep market declines?

Not so much.

The science bit: As well as the multiplication, we now have addition in our sums. So the order now matters.

Withdrawal symptoms

More scarily, the same thing happens when you’re withdrawing money.

I say “more scarily” because there’s not much you can do about your savings once you’ve stopped earning.

At least if you’re dealt a rubbish hand while you’re still accumulating money, you can try to find more cash to invest before you retire. You might even enjoy a market rebound on the extra cash you put in.

Once you’re retired though, you’ve no choice but to spend less and cancel your subscription to Caravan Monthly.

Imagine you had £100,000 in 2008. For the sake of this example let’s say you kept it all in the stock market, and you withdrew £4,000 a year.

In the table that follows the third column shows how £100,000 would fare if you kept all your money invested. The fourth column shows the impact of withdrawing £4,000 at the end of each year:

Year Return Hands off With withdrawal
2008 -28.3% £71,700 £67,700
2009 27.3% £91,274 £82,182
2010 12.6% £102,775 £88,537
2011 -2.2% £100,514 £82,589
2012 10.0% £110,564 £86,848

Note: £100,000 in with no withdrawals, versus £4,000 taken out each year.

It’s no great surprise to see that taking £4,000 out a year reduces how much money you’re left with at the end.

But let’s now shift our telescope to Bizarro World, to see how its alternative sequence of returns plays out with the same £4,000 withdrawal rate:

Year Return Hands off With withdrawal
2008 10.0% £110,000 £106,000
2009 -2.2% £107,580 £99,668
2010 12.6% £121,135 £108,226
2011 27.3% £154,205 £133,771
2012 -28.3% £110,564 £91,914

Note: Alternate sequence for retirement assets on Bizarro World.

As we saw a few months ago when I began this article with the £100 example, with no withdrawals, the ‘hands off’ pot of £100,000 compounds to the same £110,564 in both sequences of returns.

However in Bizarro World with £4,000 per year withdrawals, the sequence of returns turns out to be more favourable for the retiree. She has £5,000 or so extra in her pot in 2012 than the same investor on Planet Earth.

Interestingly, this is the opposite of what we saw with regular savers on Bizarro World earlier on in this article. They did did worse over the five-year period than we did.

But let’s not get too hung up on these specific numbers.

The point is that the sequence of returns can make a difference to how your retirement plays out. Neither you nor I know exactly what those returns will be.

Don’t risk doing badly

Can you do anything to sidestep the sequence of returns risk?

Not a lot. Its impact is mainly down to luck.

You might try to guess if various markets are cheap and to shift your investments accordingly, but many – probably most – people will do worse using such active strategies than if they had just saved and rebalanced automatically.

I think the main response to sequence of returns risk should be:

  • To de-risk your portfolio by rebalancing towards safer assets as you approach retirement
  • To consider locking in some income – perhaps enough to meet your basic spending needs – when you do retire, perhaps through an annuity.

All investing involves risk. By diversifying your portfolio and playing a bit safer, you can try to reduce the role of luck, and to increase the odds of your plan working out.

Next week I’ll explain why elaborate strategies probably won’t help you much when it comes to sequence of returns risk. Subscribe to ensure you get it!

  1. Source: Credit Suisse Global Yearbook 2013 []
  2. As always it’s worth remembering a handful of markets, such as pre-communist Russia, have been completely wiped out. Never put all your eggs in one basket! []
  3. With apologies to author Terry Pratchett. []

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{ 33 comments… add one }
  • 1 oldthinker June 13, 2013, 9:53 pm

    A simple way of explaining this effect would be by looking at several charts that all start at the same point and arrive to the same point but take different routes there. If you keep accumulating, you want the chart representing the return from your portfolio to stay as low as possible for as long as possible, so that you keep buying low.

  • 2 freebird June 13, 2013, 9:59 pm

    Perhaps a simpler illustration is to imagine a 30 year return where all of the change is concentrated in either the first year or in the last year. If share prices are cut in half, the early drop means losing only half of your first installment while the late drop loses half your nest egg. It works in reverse as well, an early pop means profit on only your first installment. It’s difficult to convince a young person that the worst thing that can happen is a large early gain, assuming constant long-term returns.

    The advantage from dollar cost averaging can be mirrored when cashing out during retirement if you switch to share proceeds averaging. In other words sell a fixed number of shares every year. The downside is fluctuating income, a concept that I imagine is familiar to most who work in private industry, especially at the higher income levels. For the uninitiated this means setting aside an emergency cash reserve to buffer the lean years.

    I don’t see a straightforward way to mitigate the sequence of returns problem at low cost. One can rebalance every year to leave only one installment exposed, but in a growing market, this is a recipe for severe underperformance. Some amount of rebalancing is certainly appropriate, however, because I see giving up wage income with a 100% equity exposure as far too risky.

    In my own case I have kept a 50/50 balance throughout my life– and made up for my underperforming early years by doubling my savings rate. The way I see it I gave up some frivolous spending in my youth to sleep better in my middle age, and I must say it was well worth the price.

  • 3 dearieme June 13, 2013, 10:02 pm

    In my years of being interested in equities I scored as follows.

    1989: started buying equities, mainly investment trusts in PEPs and a pension.

    1999: equities having gone mad, sold the lot, buying gilts and convertibles. Excellent decision.

    2003: in the Spring read that equities were cheap but did nothing about it because my attention, time and energy were exhausted by the consequences of illness and death in the family. (I imagine that this sort of thing is a known curse of DIY investment.) Failure to reflect and act proved costly in terms of opportunity lost.

    2008: decided that the condition of developed economies would justify further falls so didn’t buy equities. Obviously I completely underestimated the effect of government monetary policies, so perhaps an opportunity lost. But somewhere in there I put a fair lump into the Physical Silver ETF in an ISA which has done very nicely indeed, even now. So that compensates for not buying equities.

    2010: bought a Physical Gold ETF
    2013: sold it to help pay off the mortgage.

    If the market would obligingly crash as our Cash ISAs mature, I’d expect to buy equities again. Have not the first idea when to sell the silver ETF. If don’t know, won’t trade.

    The annual sums involved have been modest but they do add up.

  • 4 Greg June 13, 2013, 10:22 pm

    As you’ve touched on, the current generation who are retiring now had a huge bull market for stocks while they were in them when they were younger, then a huge bull market in Gilts when they were in them when older. (In addition to being able to get a job easily in the aforementioned stock bull market and safely bedded in when things went pear shaped.)

    Couple that with running up an amazing level of public debt and the same again of off balance PFI debt, as well as the fact they hived off all our public industries and used all our gas, they might have a bit more sympathy with us youngsters.

    Oh wait, there’s more! Want to educate yourself so you won’t be made ‘not economically viable’ by people in emerging markets, or stuck doing tough, menial, poorly paid work? Why that will be £30,000! Want to live in a gloomy ex council flat in London? Why that will be £350,000 please!

    In Camden, not exactly the fanciest place in the world, median house price divided by median salary is sixteen. Sixteen!
    http://www.retirementinvestingtoday.com/2013/05/valuing-london-property-at-borough-level.html

    I suspect that the people retiring now will have the best deal of any retirees for the next 50 years. (And then we’ll have global warming to worry about!) Yet they still aren’t happy!

    (I realise the ones that are fuel poor probably aren’t the ones that messed everything up, but that makes it worse, not better.)

    :@

    More related to the article, the volatility is such that one might massively under-perform for one’s entire life. The range of final returns produced by a simple Monte-Carlo is amazing. Enough to make a mockery of the nice, smooth curves in all the guides!

  • 5 Grumpy Old Paul June 14, 2013, 9:08 am

    @Greg,

    I didn’t vote for “running up an amazing level of public debt and the same again of off balance PFI debt, as well as the fact they hived off all our public industries and used all our gas” and opposed all of those policies at the time when they were very fashionable. So please don’t blame me Guv!

    However, I am appalled by the selfishness and lack of sympathy by my contemporaries and elders to the plight of younger generations. My hackles rise whenever I hear an ignorant old bigot say “I’ve paid taxes all my life”, claims to be entitled to free everything and still whinges about being hard done by. Typically, the total of that individual’s lifetime tax and NI contributions probably cover just the cost of a few years of their State Pension and NHS usage.

    I’m rather surprised that there hasn’t been more inter-generational tension.

    @The Investor,

    Good article making points I’ve never seen before and highly relevant to an old buffer like me planning to run down my savings and investments during a dissolute retirement! I’ll really have to give this some serious thought.

  • 6 vanguardfan June 14, 2013, 9:28 am

    Hi
    A really pertinent post on a topic that gets far too little attention. When you think about it, the idea of basing any projection of investment returns on simple linear assumptions, as thought they behaved like bank deposits, is so misleading its amazing that the FCA allows the industry to get away with it.
    A probabilistic approach is necessary, such as the FIRECalc model (though based on US data so will give an overly optimistic picture for UK residents) or the data in Tim Hale’s book, looking at the expected frequency of returns over all the possible 10 or 20 year periods for which we have data.
    Its salutory to note that even the best laid plans cannot ever be certain – we cannot control (or even have much idea) whether our particular 20, 30 or 50 year investment period will turn out to be favourable.

  • 7 Curious-Sarah June 14, 2013, 9:57 am

    Tell me why do I only ever read about things like this on Monevator?

    (Thank you I am not complaining — just saying I never read about this once in years of reading The Motley Fool books or website etc).

    Well another thing to worry about then. I mean another thing to overcome! 🙂 🙂

  • 8 Monk June 14, 2013, 10:00 am

    I remember sitting opposite an irate pensioner on the long seat on the number 48 bus on route to Victoria way back when I was tender of age. She was criticising the length of skirts worn by the majority of the mini skirted female passengers while indifferent to the gaping chasm between her knees that foisted sight of her drawers on the unwilling sets of eyes seated on the other side of the bus.

    There’s always been inter-generational tension.

    And claims that we’ve/they’ve/he’s/she’s never had it so good regularly feature as far back as I can remember.

    The blame game is a long and arduous one and one that’s never really produced an outright victor. It’s one of those games that’s best avoided, a bit like find the lady where you’re convinced you know you’re right long after the deck has been packed away and you’re out of pocket.

  • 9 L June 14, 2013, 10:14 am

    An important and comprehensive post TI.

    I think there is one thing you can add. Namely, the importance in saving towards a large savings/investment pot and then prudence in the addition and drawing of cash.

    Let me explain. If you keep your withdrawals constant, as your pot becomes larger each withdrawal becomes a smaller the proportion of your net worth. This is importance as this limits the exposure of your total net worth to the sequence (arithmetic compounding) of returns.

    In the most extreme example, take a billionaire who withdraws only £1 each year. The effect of the above is tiny. However, imagine that that billionaire decides to withdraw all(!) of his net worth into cash at one point in time. The effect is massive. Can you time exactly when to do this? Empirical evidence says it’s difficult, and why take the risk? Even though this is an extreme example, it’s not necessarily far from reality. For example, the 25% tax free pension withdrawal. As always, it’s important to plan ahead. It won’t solve the problem. But it will make it less of a problem.

  • 10 Luke June 14, 2013, 10:21 am

    ‘People who retired in the late 1990s as the stock market soared were laughing.

    People who retired in 2003 after several steep market declines?

    Not so much.’

    Very true – I find one of the most annoying trends in personal finance blogs being an almost universal failure to acknowledge luck. There are quite a few names that spring to mind.

    It’s one reason why I find the Monevator blog a breath of fresh air – the Investor admits his mistakes (I assume the Accumulator has made none 😉 )

  • 11 dearieme June 14, 2013, 11:51 am

    “they hived off all our public industries”: “public” my eye, they were government-owned industries. Flogging them off was wise.

  • 12 The Investor June 14, 2013, 12:39 pm

    Hey chaps, can we please stick to the topic for this post. It’s an interesting discussion but I’d rather the comments were focussed on this subject rather than politics. Much appreciated!

  • 13 Paul Claireaux June 14, 2013, 1:00 pm

    Good piece.
    Yes returns are indeed path dependent.
    Very people know this and it’s worth knowing.
    BTW this issue is also behind the flaws in that famous Dalbar survey

  • 14 Colin June 14, 2013, 1:32 pm

    Arithmetic average is never appropriate for this type of calculation , only geometric is correct, which rather defeats the first point of the article.

    Secondly if you have a good run of returns you want to do it when you have lots of assets , if you are adding funds over time, then you get the maximum return if you have a lot of money, conversely if you intend to retire with your assets in shares, and why not , you may live longer in retirement then work, by derisking you lose the opportunity of getting the maximum benefit from stock market rises. If rackets double I want it in year 30 not year 1

  • 15 BeatTheSeasons June 14, 2013, 1:52 pm

    It’s a long time since I studied mathematics, but I think there’s something wrong with these calculations. Surely you can’t just add up percentages and multiply by the number of years?

    I think the issue is that you’re using a set of periods with arbitrary length of 365 or 366 days. If you moved to Mars (and found a wireless connection) you might start tracking your investments in 669 day periods to match Martian years. That would give you a different set of percentages but the same total return.

    I agree that the timing of capital inflows and outflows makes a difference, but isn’t that just the same as saying your return is a weighted average according to how much you owned and when?

    Seeing as there is no way to predict when the ups and downs will happen, this is surely why it’s recommended to use pound cost averaging as Freebird mentions.

    And given that the long term direction is hopefully upwards there is truth in the mantra about ‘time in the market’ rather than ‘timing the market’.

  • 16 Greg June 14, 2013, 2:04 pm

    One plot I’d like to see is a fan plot of the returns over a ten-year period starting over each of the previous 50 years or so. (Giving 50 little lines, which might have to be merged into a density plot to be clear). I realise finding an index that has been around might be tough.

    The same could be done for various indexes: Stocks, Gilts, cash, cash at rates that small savers can get, various mixes of the above and even a changing mix (e.g. 90-10 the first year falling each year.) Including annual contributions would be another nice addition.

    That would prepare people for the (scary) investment journey ahead of them quite well.

    Heh, I might actually do all the above at some time in the medium future, unless you fancy it?

  • 17 Greg June 14, 2013, 3:01 pm

    @BTS

    There are two main points in the article:
    1) If you had one big lump sum and thought you could find out the returns by taking the arithmetic mean of the yearly return and then multiplying by the number of years, you are wrong. For annualised returns you must use the geometric mean. (This is the main difference between CPI and RPI, not housing as the dim-witted media go on about.)

    As TI touches on, this is easy to understand if one of the years is -100%. Imagine the following annual returns:
    +25%, +25%, +25%, -99.99999%, +25%
    An arithmetic mean would suggest you are break even, but clearly, you have effectively lost the lot.

    2) Most people don’t just have one lump sum. clearly, if you are adding money each year, the later years matter more! Bizarrely, most guides just don’t cover this!

  • 18 The Investor June 14, 2013, 3:47 pm

    @BTS — I see Greg has kindly replied, but anyway I’m not doing what you’re saying to compound those returns. Perhaps I wasn’t clear, as I’m not sure where you’ve got that from. (Perhaps the aside about the 3.9% arithmetic average? Even then you’d divide by the number of years, not multiply, to get the arithmetic average).

    You’re right though that the point of the article isn’t spectacularly deep! 🙂 It’s just massively overlooked and misunderstood.

    Was it you and I who had the big discussion about dollar cost averaging? I forget. Anyway as I’ll touch on in part two, DCA-ing doesn’t exactly beat sequence of returns risk, although it would flatten the range of possible outcomes (good and bad). Academic research shows that over more periods than not you’d be best off just investing a lump sum right away if you’ve got one if you wanted the best chance of the best return.

    The reasons to DCA are mainly emotional/psychological (and those are very good reasons!) and also to potentially avoid rare and catastrophically bad outcomes — there may also be certain instances when one is able to see it’s a terrible time to invest a meaningful lump sum. (e.g. 1999, but is that only with hindsight? By definition yes for most people, since most investors were fully invested, which is why we had a bubble in the first place…)

  • 19 oldthinker June 14, 2013, 6:14 pm

    @The Investor

    > Academic research shows that over more periods than not you’d be best off just investing a lump sum right away if you’ve got one if you wanted the best chance of the best return.

    This is an answer to the wrong question. For many (most?) investors the goal is not to maximize the mathematical expectation of their return but to maximize the probability of achieving their target return, because their financial security in retirement is dependent on achieving it. This is a very different goal, especially when the target is reasonable, and pursuing it may require a different strategy. For example, I would not take a chance of overshooting my target by 20% if the downside was an equal chance of undershooting the target by 10%; if I was interested in maximizing the expected return only, I would, of course, take such an opportunity.

  • 20 The Investor June 14, 2013, 6:39 pm

    @oldthinker — I agree, and allude to as much in the line after the one you’ve quoted. 🙂

    More thoughts here: http://monevator.com/risk-and-investment/

    But I was replying to a comment about sequence of return risk, and DCA being a potential solution. It’s not really, IMHO.

  • 21 Paul Claireaux June 14, 2013, 7:06 pm

    To The Investor
    I agree that for the regular investor / saver their returns are highly path dependent. We should all be aware of this when reading the oft quoted surveys about how returns are lost through timing mistakes (Dalbar)

    And to old thinker (from another old thinker)

    I take your point about meeting our goals being more important than achieving some grand total return.

    But I’m not sure how anyone can go about maximising the probability of achieving their target return without taking a view on valuation.

    You can use individual gilts to guarantee nominal returns but what if inflation in the cost of your target starts to go through the roof? You will then want to be out of that gilt and into something with better inflation protection properties. Trouble is at that time it’s too late and your gilt holdings are already smashed.

    I’m not sure there’s any simple answer to investing but keeping an eye on valuations is a good starting point w.r.t. protecting what you have.

  • 22 ermine June 15, 2013, 9:42 am

    @Greg > clearly, if you are adding money each year, the later years matter more!

    I agree with that, but everybody else says the early years matter more due to compound interest 😉

    My experience of lifecycle saving was that it was really hard at the start and got much easier later on, and tax advantages etc were better later on (because of the 40% tax relief making savings punch much higher later).

  • 23 The Investor June 15, 2013, 10:24 am

    @ermine — Hi! 🙂 Remember that “matters more” and “will be hit by down years in the market more” are two different things. If you are “all in” equities, at one extreme, when you are 60 and want to retire at 65, then the later years clearly matter an incredible amount and you are running a large degree of risk. But if you are 60 with say a 60/40 diversified portfolio minimum (and ideally something with cash, property, maybe a small amount of gold, etc) then you have a different risk profile.

    You can spend hours messing about with spreadsheets to model all sorts of scenarios. I suspect there have been periods when investing tuppence (figuratively speaking) in the market at 20 and investing hard for 10 years then switching to cash or bonds for the rest of your life saw compound interest lift you clear. Other times dithering about with the stock market for a decade badly lagged cash (say an index investor looking at their results in 2010, though dividends would have helped, and as we’ve discussed in the article and in these comments a regular saver throughout the decade would have been buying at the bottom as well as the top…)

    Bottom line, it’s a *risk*. By definition, risks can’t be totally accurately modeled, and there’s no one size fits all rule except in hindsight.

    Indeed I sometimes think that’s where more scientific / mathematically inclined and brainy people go wrong when investing. They yearn for certainty, and move from one failed relationship with an asset class or strategy to another. A messy orgy of all the above is the best way to mitigate risk! 😉

  • 24 Paul Claireaux June 15, 2013, 10:44 am

    To The Investor.
    Very fair point there – about the mathematically minded (me included) who definitely do yearn for certainty.
    It’s only in recent years that I’ve learned there isn’t any way of having it – or anything close to it.
    Yes, a mix of assets is best once you’ve accumulated something -but with the most informed tilt you can give it towards better value markets.
    I like CAPE for this but we need to go easy on that metric too or we’ll end up filling our boots with Greek shares! And we have to remember that when economies truly collapse there is a really risk of communist government confiscating the lot!
    For younger savers – who have their contingency funds in place – i think pure equity investment is just fine – but again try to accumulate in markets with better growth prospects longer term.
    My personal feeling is that the USA is already on very stretched valuations and we could see a long Japan style decline there so I’d not allocate much there right now.
    Maybe after a big correction though . . .

  • 25 SemiPassive June 15, 2013, 11:58 am

    Even plumping for markets with “better growth prospects” is flawed, look at the lousy performance of emerging markets indices compared to the “busted, indebted” Western markets over the last year.Maybe an emerging markets tracker will trounce a world tracker over the next 20 years, but there is no guarantee.
    And at the other end of the age scale, “de-risking” into govt bonds is anything but.
    I think in terms of what I hold in SIPP and Shares ISAs I will probably stay at 60% equities (rest in index-linked gilts and corp bonds) forever now.
    Any reduced exposure to the stockmarket will probably be achieved
    by gradually increasing the % of net worth held outside of SIPP, eg cash and property, and maybe even a little gold rather than ramping up and down equity exposure within my pension wrapper itself.

  • 26 The Investor June 15, 2013, 12:16 pm

    @SemiPassive — For somebody who holds zero government bonds, I seem to spend an awful lot of time talking about why they’re not as bad as the worst critics say.

    You write:

    And at the other end of the age scale, “de-risking” into govt bonds is anything but.

    Au contraire, my friend, moving equities into gilts is absolutely de-risking your portfolio.

    Have a look at this table of UK gilt yields. Look at the “yield” column on the far right, and ignore the perpetuals (undated) bonds at the bottom.

    What you will see is that every single gilt has a positive “yield to maturity”. This means if you bought and hold to maturity any UK government gilt, you would get all your money back, plus a bit more.

    Are the yields pathetically small? Yes, especially at the short-end.

    Are any of those with less than 10 years to run to maturity likely to beat inflation? Nobody knows, but I’d say the chances are not.

    Are they less risky than an index tracker fund that can and will at some point fall at least 25% in a year and maybe as much as 50%?

    Absolutely. Swapping equities for gilts absolutely reduces your risk.

    Some people seem to equate “less risky” with “more attractive”. I agree government bonds are not more attractive right now — personally I’d say far from it. I hold none, and expect equities to grossly outperform over the next 10-20 years.

    But government bonds ARE less risky.

  • 27 SemiPassive June 15, 2013, 12:35 pm

    I was thinking in terms of gilt funds at todays yield/valuations, but if you’re talking holding individual gilts for their remaining duration then I see what you mean – inflation risk aside.
    I intend holding some individual corp bonds for their duration, but for the index linked gilts (which rightly or wrongly I see as less risky) I use a fund.
    On a kind of related note I took advantage of a fixed term 1 year cash offer at 2% in my H-L SIPP last October, instead of buying conventional gilt fund due to my aversion.

  • 28 The Investor June 15, 2013, 8:06 pm

    @semipassive — Nice move on the SIPP cash IMHO. I agree holding cash is a decent substitute for bonds for private investors (not an exact swap, but on today’s tiny yields not far off except at the longest and riskiest end! 🙂 ).

  • 29 oldthinker June 15, 2013, 10:23 pm

    @The Investor

    > Au contraire, my friend, moving equities into gilts is absolutely de-risking your portfolio.

    This depends on what kind of risk we are talking about. I am predominantly interested in the risk of not achieving the target return. My target is realistic but absolutely not achievable by investing in gilts only (I would not be invested in equities otherwise). So switching from equities to bonds would, beyond a certain point, increase the risk that matters to me. If the uncertainty of the outcome was the only risk that mattered, moving the whole portfolio into physical cash and then burning it would be a jolly good way of de-risking 🙂

  • 30 dearieme June 17, 2013, 4:45 pm

    I advocate opportunism. When Index-Linked Savings Certificates were available from ns&i, “everyone” should have bought some: they offered a unique combination of security, real return, nominal return and tax efficiency – so much so that they would obviously be withdrawn from sale eventually. And they were.

    Similarly, quite recently Building Societies were offering fixed interest Cash ISAs at excellent rates, with not too onerous penalties for early encashment – my wife opened a five-year one paying 6% p.a. That opportunity too seemed unlikely to last long, and so it proved.

    Such investments don’t feature in the usual discussion of cash vs equities vs bonds, and they aren’t available to the fund managers who compete vs benchmarks, but by golly they are handy for the private investor of modest means.

  • 31 Troy rieck August 4, 2013, 7:35 am

    If you want to look at someone doing serious work in this area of finance, look for Prof Michael Drew at Griffith University in Australia.

    The underlying point is very insightful precisely because it isn’t rocket science, just completely absent from conversations between almost all investors and planners until the last five years or so.

    Investors should reduce their exposure to valuation risks over time (as their cash flow profile turns from inflows to outflows). They should be sensitive to valuations at any point in time as well – own more equities when thir prospective returns are generous compared to when they are miserly etc. And consider the costs and benefits of certain forms of tail risk hedging strategies: valuations risk for assets, inflation risk, longevity risk etc – you don’t have to use them, but you should be aware of the costs of buying greater certainty over time.

  • 32 Planner September 5, 2013, 5:58 pm

    You can completely eliminate sequence of returns risk in the spending phase by spending the same percentage of your remaining portfolio balance every year. You can see the math at my blog post. “Clarifying Sequence of Returns Risk”. Just Google it.

  • 33 The Investor September 6, 2013, 8:52 am

    Hi Planner — Just read your interesting post. I think a better word would be to say can ‘replace’ or ‘substitute’ the risk, and in my opinion that doesn’t even really cover it.

    I do understand what you’re saying and I do see how the maths works. As you say in your post there’s an element of semantics or opinion here about what the actual risk is.

    A retiree who spent 4% of a larger number one year and 2% of a smaller one the next is clearly falling foul of risks of some sort, we can both agree! 🙂

    Anyway, I’ll try to include your article in my weekend reading post tomorrow as it’s good food for thought.

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