Sequencing Risk
By: Dylan B. Minor, PhD, MS, CFP®, ChFC, CLU, CIMA®
Chief Investment Officer
There are many risks we must face as investors. The subject of this short article is the investing risk we dub sequencing risk. Sequencing risk has to do with the (bad) risk of needing to pull money out of a portfolio during a particularly poor performance year and the (good) risk of being able to add money during a down year. For example, is your worst annual return the first year you begin investing or does it occur just before your first year of retirement income withdrawals?
Interestingly, you are only exposed to sequencing risk when you add or take money from your portfolio beyond the beginning and end of the portfolio. To see how this works, we first show an example of only adding and withdrawing money from a portfolio at the beginning and end of its investments.
Sequencing Risk- no cash flow changes
Consider the very simple example of an investment that has a +100% return for one period and then a -50% return another period. This could be, for example, from the previous Bear Market trough through last market peak of 2007 that created a roughly 100% gain, and then following the most recent Bear Market trough representing a roughly 50% drop.
Now if you invested $100 at the beginning of the 100% gain period, you would have precisely a zero return: $100 grows to $200 (i.e., 100% gain) but then loses 50%, bringing your $200 back to $100. What if instead returns happened in the opposite order: the 50% loss happened first and the 100% gain second? That is, here, you sadly invested $100 just before it fell 50%. Well, amazingly, you actually end up with the same zero return: $100 falls to $50, but then $50 grows to $100. It can readily be shown this simple example generalizes to any return sequence of any (finite) length. As long as one invests their money at the beginning and doesn’t withdraw any (or invest anymore) funds until the end, the order of returns have no bearing on one’s final asset value. However, if there ever is a cash flow change before the investment period is done, things can change, and change quite drastically.
Sequencing Risk- with cash flow changes
Now let’s use the same example but add cash flows. First assume we invest $1 and the investment first makes 100%. This means we now have $2. What a great return! Now we add $98, to bring our account value to $100. Sadly the next period, this $100 falls to $50. We have now lost almost 50% of our original investment. However, remember from the first section, the actual investment return was zero!
Now this risk cuts both ways. Let us say now we had invested $1 and the investment first loses 50%. This means we now have just $.50. However, we nonetheless decide to add $99.50 to the account. Now the investment makes 100%, and our ending value is a whopping $200, or roughly double our total investment of $100.50! All the while the investment itself actually made zero return, as again shown in the previous section.
What a difference the year of monies being added (or taken out) can make on the ending value of the portfolio, even when the investment itself can have a good, bad, or zero return. So what should we do? We wish we could just make investments and then backdate paperwork to take advantage of this sequencing risk. Unfortunately, we cannot do that. But what can we do? Our final section now covers 4 strategies that have the potential to mitigate some of this sequencing risk.
Sequencing Risk Strategies
1. Staggered Withdrawals
The first strategy is if one has a large contribution or large withdrawal to make to a portfolio, she can average the money in (or out) of the portfolio over a period of time. For example, let us say a client needs to withdrawal $90,000 from a portfolio, she can divide it up into three $30,000 pieces and take it out over 3 months. This way his success or failure is not as dependent on taking it out at just the right day.
2. Liquid Reserve Fund
A second strategy is to keep roughly up to two years of expenses in liquid types of funds. This way, if financial markets have a tumultuous fall, one can wait for two years until needing to tap the portfolio, instead only tapping his short-term liquid funds as needed. This then allows time for a recovery and averting his needing to take funds out at a terrible time.
3. Portfolio Barbell
A third strategy similar to the last is to actually develop as part of one’s allocation and investment policy statement to more conservative short term investments. That is, the investment and return potential would be similar to a traditional allocation with more similar risk and return investments – we refer to this strategy as portfolio barbelling.
Although these more conservative short term funds are not FDIC insured and can still fluctuate in value, they tend to have significantly less price volatility. Hence, should the portfolio need to be tapped there is a much better chance one could tap these more conservative portfolio slices and thus not have to touch the more volatile slices during an adverse time. Contrarily, when the sequencing risk is positive, then the riskier slices may be available for a withdrawal at a profit.
4. Non-correlated Diversification
A final strategy is to make sure one has investments that are not all correlated. Thus, even within one’s riskier investments, to make sure one is using alternative and other kinds of investments so when facing a negative sequencing risk, not all slices of one’s portfolio are down as much. Or, perhaps, you may even have one risky slice up when another is down. This non-correlated type of diversification may help reduce sequencing risk (Please note: Diversification does not assure profit or guarantee against loss).
This approach is not a trivial task, as our last credit crisis has shown: some investments can be quite correlated even though they intuitively seem to be different.
We have discussed the unavoidable risk of sequencing risk: as long as one will vary her cash flow over time, she will face such risk. Thus, we discussed several strategies that may help mitigate it. As always, any investment decision must be made within the context of one’s overall investment plan. If you would like to learn further about managing sequencing risk or any other part of our consulting process please feel free to write or call.
**This article was written by Dylan B. Minor MS, CFP®, ChFC, CLU, CIMA® – Chief Investment Officer – with Omega Financial Group, 812 Anacapa Street, Santa Barbara, CA 93101, and 805-617-4363.
Omega Financial Group is a Registered Investment Adviser. This article is solely for informational purposes. Advisory services are only offered to clients or prospective clients where Omega Financial Group and its representatives are properly licensed or exempt from licensure. Past performance is no guarantee of future returns. Investing involves risk and possible loss of principal capital. No advice may be rendered by Omega Financial Group unless a client service agreement is in place.
The opinions expressed here reflect the judgment of the author as of the date of the report and are subject to change without notice. Any market prices are only indications of market values and are subject to change. The material has been prepared or is distributed solely for information purposes and is not a solicitation or an offer to buy any security or instrument or to participate in any trading strategy. Additional information is available upon request.