Sequencing Risk

How financial market volatility affects investors at different life stages

Many people understand that volatility in financial markets can affect the value of their investments. Taking a closer look at sequencing risk, we will explain how the order of investment returns can have a significant influence on the value of investors’ retirement savings.

Does the order of returns really matter?

In reality, the order of investment returns does not matter too much for most long-term investors. While nobody likes to see the value of their investments going down, irrespective of the ‘return path’ or order of returns, an investment will have risen in value as long as the average return is positive.

This is illustrated in the stylised example in Table 1. Investor A and Investor B invest $1,000,000 in different products – the table highlights how both investments performed over 15 years.

Table 1: Impact of the ‘return path’

End of year Annual return Investor A Annual return Investor B
$1,000,000 $1,000,000
1 -14% $860,000 26% $1,260,000
2 -4% $825,600 23% $1,549,800
3 -22% $643,968 19% $1,844,262
4 15% $740,563 -5% $1,752,049
5 9% $807,214 8% $1,892,213
6 -7% $750,709 -2% $1,854,369
7 -14% $645,610 12% $2,076,893
8 5% $677,890 5% $2,180,737
9 12% $759,237 -14% $1,875,434
10 -2% $744,052 -7% $1,744,154
11 8% $803,576 9% $1,901,128
12 -5% $763,398 15% $2,186,297
13 19% $908,443 -22% $1,705,311
14 23% $1,117,385 -4% $1,637,099
15 26% $1,407,905 -14% $1,407,905

Source: First State Investments. Table is used for illustrative purposes only.

Both investments deliver the same returns, but the order of those returns is reversed for the two investors. Investor A’s investment delivers three consecutive years of negative returns early in the period, while Investor B’s investment delivers negative returns at the end of the period.

Assuming both investors stay invested for the full 15 years, it is clear that the order of returns had no impact on their final investment balance – both investments have grown to $1,407,905. This is because positive and negative market movements have averaged out over time. Importantly, despite the volatility in annual returns, the average return is positive.

For this reason, most people saving for their retirement should not be overly concerned about short-term volatility in markets, even though this can result in short-term downward movements in the value of their investment. Assuming that the long-term average return is positive, the value of their investment will grow.

Does anybody need to be concerned with volatility then?

One group of investors in particular needs to think about volatility and the order of their investment returns – retirees. The following example illustrates how the order of returns affects them. Let’s assume Investor C and Investor D are both 65 years old and about to retire. In order to help finance their day-to-day living costs, both investors withdraw $5,000 each month, or $60,000 per year, from their investment.

Table 2: Impact of the ‘return path’ with regular withdrawals

End of year Annual return Withdrawal Investor C Annual return Withdrawal Investor D
$1,000,000 $1,000,000
1 -14% $60,000 $800,000 26% $60,000 $1,200,000
2 -4% $60,000 $708,000 23% $60,000 $1,416,000
3 -22% $60,000 $492,240 19% $60,000 $1,625,040
4 15% $60,000 $506,076 -5% $60,000 $1,483,788
5 9% $60,000 $491,623 8% $60,000 $1,542,491
6 -7% $60,000 $397,209 -2% $60,000 $1,451,641
7 -14% $60,000 $281,600 12% $60,000 $1,565,838
8 5% $60,000 $235,680 5% $60,000 $1,584,130
9 12% $60,000 $203,962 -14% $60,000 $1,302,352
10 -2% $60,000 $139,882 -7% $60,000 $1,151,187
11 8% $60,000 $91,073 9% $60,000 $1,194,794
12 -5% $60,000 $26,519 15% $60,000 $1,314,013
13 19% $60,000 $0 -22% $60,000 $964,930
14 23% $60,000 $0 -4% $60,000 $866,333
15 26% $60,000 $0 -14% $60,000 $685,046

Source: First State Investments. Table is used for illustrative purposes only.

Again, the two different investments deliver the same percentage returns, but the ordering of the returns is reversed.

The investment outcomes of Investor C and Investor D highlight how sequencing risk (or the order of investment returns) can be crucially important around retirement age. At this time, investors are typically making the transition from savers to income-seekers – from building up their nest egg to drawing income from it. If financial markets struggle around the time of retirement, there could be undesired consequences such as delaying retirement to continue working, or having to reduce expenditure in retirement.

This is the clear problem for Investor C. Regular withdrawals, combined with a series of negative investment returns in the first three years of retirement, mean Investor C has less time to recover from negative market movements. In the above example, Investor C faces the unfortunate prospect of having their funds depleted just 12 years into retirement.

Over the same period, Investor D continued to accumulate wealth during retirement despite making exactly the same withdrawals as Investor C. This is because Investor D had the better fortune of having three consecutive years of positive, double-digit returns immediately after retirement.

What can you do about sequencing risk?

The rapidly declining value of Investor C’s investment shows that sequencing risk can have serious implications for retirees. Importantly, it can make a meaningful difference to how long an investor’s savings will last in retirement and how much income can be withdrawn in order to help fund day-to-day living costs. As a result, sequencing risk must be addressed before savers reach retirement as part of a transition strategy.

One thing is for sure – volatility will remain a feature of financial markets. While nobody can control the order of investment returns, there are some steps investors can take to mitigate the effects of sequencing risk.

Mitigating the effects of sequencing risk

Diversifying your investments across different asset classes can reduce the volatility of investment returns and reduce the severity of downward movements in individual asset classes. It’s important to remember that diversification can reduce the volatility of investment returns without inhibiting total returns.

Amending asset allocation in your investments over your working life. Many investors choose to have greater exposure to growth assets early in their working life and then reinvest their assets in more defensive, less volatile investments as they approach retirement.

Adjusting the rate of savings during your working life. It may be worthwhile having a higher contribution rate early in your working life (when income is typically lower) and reducing the rate as you approach retirement (when income is typically higher).


Want to know more about sequencing risk? Speak to a BlueRocke financial adviser on 1300 71 71 36.

Negative gearing

How does it work and is it a good strategy for you?

The recent housing boom in Australia has been driven by both investors and home-buyers. According to the Australian Bureau of Statistics, investment loans hit record levels in June 2015, contributing to more than half of all new housing loans, including more than 60% of loans in New South Wales. Even as those numbers fell back in July, due to investment lending being reigned by regulators, investors sentiment continues to remain strong.

Surging prices have seen rents struggle to keep pace. According to the CoreLogic RP Data Home Value Index, annual rental income from investment properties fell to an average of just 3.3% of house prices in August — more than the interest on a typical term deposit, but less than the dividend yield on many shares. That suggests many investors may be using a negative gearing strategy, sacrificing short-term income for long term gains. But while negative gearing can be a powerful tool for building wealth, that doesn’t mean it’s for every investor or every situation. Here’s how it works, and how to decide if it’s right for you.

How it works

Gearing is simply borrowing to invest. As many investment home-owners know, it can be a winning strategy because it enables you to buy bigger and more valuable assets with less cash upfront, so you can potentially earn more income and make larger capital gains.
If the income from your investment is higher than your borrowing costs, you’re said to be positively geared. But if you pay more in interest and other costs than you earn from your investment, you’re negatively geared. In other words, negative gearing means making a loss on your investment today in the hope of making a gain tomorrow. So how can you use it as a strategy to build wealth?

Multiplying your gains

The key is that rental income is just one of the ways you can make money when you invest in property. The other, often much larger, money-spinner is the gain you make when you eventually sell, always assuming the property has risen in value. That’s because gearing also has the effect of multiplying your capital gains. Here’s a simple example. Let’s say you invest $500,000 in a property and it rises 10% to $550,000, you make a 10% capital gain. But if you invest $100,000 of your own money and borrow the rest, that $50,000 profit is 50% of your initial investment — 10 times the capital gain. For investors, this multiplying effect can often outweigh the short-term losses that negative gearing involves. But there is also a downside. Just as gearing multiplies your gains when you invest successfully, it also multiplies your losses if an asset falls in value. And remember that house prices can and do fall, especially after a period of strong gains. That’s why gearing should always be used as a long-term strategy, allowing you ride out any short-term ups and downs in the market.

Tax concessions

Of course, the other reason negative gearing is popular with investors is that it can bring sizeable tax concessions. That’s because investors can generally claim a tax deduction for their interest and costs. For example, if you’re in the highest 49% tax bracket (including the Medicare and budget repair levies), and you’re paying $20,000 a year in interest and other costs, you could receive a tax concession worth $9,800, making that expensive property look much more affordable. So while you may be making a loss today on your negatively geared investment, you can offset that loss against your other taxable income, lowering your overall tax bill. But an important word of warning: tax laws are complex, and everyone’s situation is different. So it’s essential to get professional tax advice before you commit. And while the tax concessions can make your strategy more effective, it is never a good idea to let tax influence your investment decisions. After all, a bad investment with tax concessions is still a bad investment.[1]

Getting great advice

As you can see, making gearing work is all about getting the numbers right. That’s why it makes sense to talk to a professional who can help you stress-test your strategy and find the most rewarding option with the least risk. For more information, talk to an advisor at BlueRocke at 1300 71 71 36.


[1] Seek advice from an accountant regarding tax concessions for your personal situation.