There is one, immutable ‘law’ of investing which states – in order to achieve greater returns you have to expose your funds to the risk of loss. Consequently, it is the management of this risk/return ratio that becomes the hallmark of a successful investment.
Unfortunately, the world not being as perfect as we would like it seems to throw ‘curve balls’ at our investments on a pretty regular basis with many being too difficult to ‘hit out of the park’.
A good example of this is termed ‘sequence risk’. Put simply ‘sequence risk’ is the risk of experiencing poor investment performance at the wrong time, typically when your investment portfolio balance is at its greatest.
“At the wrong time”, you say “surely getting a poor return is always at the wrong time?” It most certainly is, but with long term investments such as superannuation, the timing of losses are incredibly important.
For example, a negative 10% return for your super fund in its first few years would be easy to accept. Your balance in those years is small and a 10% reduction is barely missed.
But it becomes a much different story if that negative return occurs a year before you retire. This is the time that your fund has had the benefit of 30 years of continuous saving and returns, and is, therefore, enjoying its highest balance.
A 10% market fall at this point results in a much bigger monetary reduction which will definitely make you think twice about your ability to retire. It is at this time that you suddenly acquire a very clear understanding of sequencing risk.
There is no absolute solution to this issue but I have always recommended that investment portfolios be transferred into cash options about 2 years prior to retirement. Yes, it does seem ludicrous to
move from an investment that has been achieving 15% return, as a result of boom conditions, into an option generating less than 3% – until of course, we get a market correction.
I recall the late stockbroker, Rene Rivkin summing it up nicely with his quote, ‘with investors, the feeling of losing money is far, far greater than any feeling of making money”
And I can assure you that when markets begin to fall, clients quickly turn into ogre’s, no matter how relaxed they were about risk when they started!
So make sure you ask your adviser about the strategies they use when dealing with sequencing risk. Alternatively, as a self-directed investor you do need to think carefully about how you might de-risk your portfolio when you are getting close to needing it.
I always suggested to clients to move more and more assets into cash the closer you are getting to needing the funds. So at least 12 months before your retirement date, the majority of your money should be cash-based.
Although this would be very difficult if you are holding just a single asset such as a property in your portfolio, which is common. And currently, against the backdrop of a falling real estate market, it is easy to see the folly of single asset investing.
The Australian retirement system actually requires the removal of assets from the accumulation phase before being placed into the pension phase. It is for this I always recommend cash investments prior to retirement day.
So ensure you spread your investment funds across a range of assets. Diversification is the number one rule of investing, and it will never let you down. So keep this in mind when you are evaluating the riskiness of your portfolio and always remember the more specific occurrence of sequence risk.
You certainly need to build strategies in order to counteract this issue, otherwise, you could obliterate many years of positive returns virtually overnight. Thank you for reading and I look forward to seeing you here again.
