The sequence counts

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The sequence counts title card: red, black and cream artwork in the style of a backgammon board

Articles by Joseph

Joseph Barker

Investment Manager

13 April 2023

You can have two $1 million portfolios with the same regular withdrawals and similar annualised returns for the investment period as a whole. But the sequence of those returns – when the gains and losses occur – can mean the difference between a final value of $0 and doubling your money. So how can investors mitigate this major threat to long-term wealth?

For a portfolio with cash flows, sequencing risk is the potential impact on the portfolio’s final value from the order in which returns are achieved – that is, whether performance is stronger at the start or the end of the investment. This is true for any investment that involves cash flows, whether withdrawals from the portfolio or additions to it.

When a regular income is drawn, the returns at the start of the investment period matter far more than the returns at the end. If the returns early on are weak, any withdrawal represents a higher percentage of the now lower portfolio value. That makes it harder for the portfolio to generate the return needed to maintain future withdrawals.

Suppose 1,237 portfolios of $1 million were invested in the S&P 500 for 20 years. Each one starts in a different month between December 1899 and December 2002, with the first investing from December 1899 to December 1919, the second from January 1900 to January 1920 and the final portfolio investing from December 2002 to December 2022. The annualised return achieved by these portfolios range between 1.6% and 18.2%.

Double or quits?

This variation in performance given different starting points is well understood; it is simply investment risk. What is less well understood is the vastly different outcomes for portfolios which achieve the same overall percentage return, but pay regular cash flows.

Of these 1,237 sample portfolios, 45 had annualised returns in a narrow range between 6.9% and 7.1%. Taking this sample set and assuming each withdrew $65,000 a year

(6.5%) in monthly instalments over the 20 years, the final portfolio values range from $0 to over $2 million. As many as a third of these investors end up with less than the $1 million they started with.

Remember: each of the 45 investors has an almost identical overall return, which is greater than their withdrawal requirement. Nevertheless, their experience differs wildly, with some losing their whole investment while others double their money. How can this be?

Click chart to view larger image

Figure 1 plots the final value of each of the sample portfolios against the annualised return achieved in the first seven years.

As we would expect, portfolios with strong early returns – the dots towards the top of the chart – generally cluster towards the right and have higher final values.

By contrast, portfolios with weak early returns are clustered towards the bottom left of the chart, signifying low final values and, in one case, a complete loss of wealth. This shows that strong performance in the initial period is crucial to achieving a good final outcome.

Accumulating problems

What is even less well understood is that sequencing risk is a problem for portfolios not just in drawdown, but also in the accumulation phase.

Let’s take the same sample set of portfolios again, but this time starting with $1,000 and investing $1,000 per month. Again, the final values across portfolios with almost identical annualised performance differs vastly, ranging from $339,588 to $852,389. In the accumulation phase, the portfolio is generally largest towards the end of the holding period, so performance then matters more than at the start.

Click chart to view larger image

Figure 2 plots the final value of each of the sample set against the annualised return in the last seven of the 20 years. Again, it shows a distinct correlation between portfolio value and returns towards the end of the investment horizon, despite near identical annualised performance over the period as a whole.

So, whenever cash flows are involved, the dollar return achieved is affected dramatically by the sequence of returns, not just by the returns themselves.

A good annualised return is not enough to guarantee a good long-term result.

Mitigating sequencing risk

In both of these examples, the results vary based on when the good and bad periods of return occur. The only way to reduce sequencing risk is to ensure the portfolio avoids any large drawdown when the portfolio’s value is highest. But this is far easier said than done.

Most pension plans try to mitigate this risk by using a sliding asset allocation. In the early years of a member’s employment, the portfolio is geared towards investments with higher risk and expected returns.

As the member approaches retirement and the portfolio gains in value, investment risk is decreased on a sliding scale, typically by reducing the portfolio’s exposure to equities, in favour of bonds. Whilst this lowers the expected return, it should also reduce the exposure to drawdowns – barring a meltdown in bonds, such as we saw last year.

For a portfolio with significant cash flow requirements, the order in which returns are achieved matters a great deal.

GMO has produced a white paper which takes this approach a step further.¹ As well as reducing exposure to equities with age, it suggests varying the allocation depending on equity valuations. The paper argues that buying equities when they are undervalued can improve average final portfolio values. However, many active multi-asset managers already flex their allocation to equities as valuations change, so this solution will often be already incorporated into portfolios. Besides, it improves final values mainly by increasing overall portfolio performance.

For us, the more important question is how to mitigate sequencing risk across portfolios with near identical returns. One way would be an absolute return approach, which aims to avoid large drawdowns altogether and generate consistent positive returns over a specified time. After all, the sequence of returns does not matter if the same return is achieved in every period.

All in order

For a portfolio with significant cash flow requirements, the order in which returns are achieved matters a great deal. Percentage returns tell only part of the story, and we believe the potential impact of sequencing risk should be given careful consideration before making any investment.

Inker, Montier and Tarlie (2022), Investing For Retirement III: Understanding and Dealing with Sequence Risk

This article first appeared in The Ruffer Review 2023.

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The views expressed in this article are not intended as an offer or solicitation for the purchase or sale of any investment or financial instrument, including interests in any of Ruffer’s funds. The information contained in the article is fact based and does not constitute investment research, investment advice or a personal recommendation, and should not be used as the basis for any investment decision. References to specific securities are included for the purposes of illustration only and should not be construed as a recommendation to buy or sell these securities. This document does not take account of any potential investor’s investment objectives, particular needs or financial situation. This article reflects Ruffer’s opinions at the date of publication only, the opinions are subject to change without notice and Ruffer shall bear no responsibility for the opinions offered. This financial promotion is issued by Ruffer LLP, which is authorised and regulated by the Financial Conduct Authority. Read the full disclaimer.

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