We all understand the importance of risk management in investment, yet the impact of sequence risk, or sequence-of-returns risk, is less well known. Investors often believe this risk only affects portfolios post retirement, but it affects any investment with cash flow. Therefore, you need a strategy to manage the impact of sequence risks in your portfolio.

What is sequence risk?

Whenever cash flow is introduced into your portfolio by withdrawing funds, you open yourself up to sequence-of-returns risk. However, it does not affect an investment without cash flow.

What is the impact?

Sequence risk causes similar portfolios to experience different balances. In the example below, an investor has R1m invested at a 10% annualised return over three years. If there is no cash flow (regardless of the sequence of returns), the future value of the investment stays the same. Once cash flow occurs, however, the order in which you experience returns impacts the future value of your investment.

In base case 1, the investor withdraws R100,000 in year two, when he experiences a -30% return. This investor now has less capital to work for him, resulting in his investments growing slower. In base case 2, the investor also withdraws R100,000 in year two, but having earned a 73% return that year, he has more capital available, which results in a higher future value. Because the first investor withdrew cash in the year he received negative returns, the future value of his investment is reduced by just over R100,000.

Image: Supplied/PSG Wealth

Your financial planning philosophy should address this risk.

Products that reduce volatility can help, but only if they don’t compromise long-term growth prospects. More importantly, a sound financial planning philosophy should provide a strategy to address this risk. PSG Wealth’s financial planning philosophy aims to mitigate sequencing risk by ring-fencing your retirement assets into silos: capital stability, capital preservation and capital creation.

When income is drawn from the first silo, the investor’s capital balance is preserved in the other two until needed. The asset allocation and investment horizons for each silo are predetermined to allow specific asset allocations to deliver on their respective objectives. Varying investment horizons are used for each silo to lessen the effect that negative returns could have on an investment portfolio. This strategy ensures that parts of an investment are left to grow until it is needed for income purposes.

Sequence risk becomes more pronounced in retirement, due to the nature of funds used post retirement. Ensuring your capital can support you throughout retirement is a key challenge for retirees.

People are living longer and can spend more than 20 years in retirement on average. In addition to planning for longevity, be sure to have a conversation with your financial adviser on how to mitigate and reduce sequence-of-returns risk.

For more information, visit psg.co.za.

Adriaan Pask is the chief investment officer at PSG Wealth.

This article is paid for by PSG Wealth.