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Here’s a quick recap on the definition of sequence risk, or sequence-of-returns risk – it refers to the risk an investor triggers when performing multiple withdrawals over a period of time. In other words, if there is no withdrawal from the portfolio, there is no sequence risk, making the term “sequence risk” an unfortunate misnomer.
To illustrate, let’s use the S&P 500 returns for the period 1989 to 2008. Ms Forwards inherited S$1m at the beginning of 1988, which she invested fully in the S&P500. In 20 years, she ended up with more than S$4.9m.
In an alternate universe, Ms Backwards also inherited S$1m at the beginning of 1988, but she faced the exact reverse order of returns that Ms Forwards encountered. At the end of 20 years, Ms Backwards had nearly S$5m – the same amount as Ms Forwards, down to the last dollar of $4,985,366.
Even though there is a different sequence-of-returns, the outcome at the end of 20 years was identical. You can try an alternate sequence of returns, and realise that sequence is irrelevant. This is in fact the normal state of things – a different sequence-of-returns will not normally affect your investment portfolio value unless you perform periodic withdrawals. This is why sequence risk is counter-intuitive to some.
The reason for this occurrence is geometric mean. Let’s simplify the example by considering only two years of returns – a negative 20% returns followed by a 25% returns, and the reverse situation. Starting with S$1m, the ending point after two years is back to square one for both sequences, implying sequence of returns does not matter.
This rule can be generalised in the calculation of the geometric means of a series of returns. In this case, the series has the same geometric mean of zero per cent [√((1-0.20) x (1+0.25)) – 1 = 0%].
In some cases, luck and timing could be very important because of the inherently unpredictable nature of the financial markets, but it doesn’t mean that you have no control when planning for your retirement.
Studies have shown that graduates who entered the job market during a market lull suffered large initial earnings losses as compared to their peers who graduated in the boom before the bust. Graduating during a recession typically leads to salary losses of about 9%. The gap narrows over the next five years, but doesn’t really go away for a full decade.
That is an unfortunate interplay between luck and timing, but it is not all doom and gloom as there is still some form of control. For instance, if a recession hits and it seems likely that the student will graduate in the middle of an economic meltdown, the student still has some choices, which includes delaying graduation, securing an internship, or seeking higher qualifications before entering the job market.
This is not infallible advice and there are real-life situations where this may fail, such as in a protracted recession (which Japan has experienced over the last 20 years). This strategy may work only for shorter recessions. That is why it is important to take calculated risks and make considered decisions to remind ourselves that we’re not totally helpless in the face of luck and timing.
One of the things we do know is that starting withdrawals in the first years of retirement during a recession is highly damaging to a portfolio. If the country is in a recession and you are nearing the retirement age, you could choose to defer your retirement to tide you over or choose a part-time retirement and withdraw less during the first few years.
You may also apply ideas of a rising equity glide path, which is an asset allocation strategy that advocates exposing your retirement nest egg to the lowest risk at the beginning of your retirement, rather than at the end. Always remember that there are many strategies you can apply to safeguard your retirement portfolio even in the face of difficult circumstances.