Learn To Invest
Stocks Special Reports LICs Credit Funds ETFs Tools SMSFs
Video Archive Article Archive
News Stocks Special Reports Funds ETFs Features SMSFs Learn
About

News

Sequencing risk - why young investors need to be careful too

Amy C. Arnott  |  18 Aug 2021Text size  Decrease  Increase  |  
Email to Friend

In my last article, I explained why sequence-of-returns risk is one of the more underappreciated dangers of investing and showed how it can affect portfolio values during retirement. But how returns unfold over time also plays a role in planning for younger investors. In this article, I’ll explain why the sequence of returns is important and give some practical tips for dealing with it.

Background

Sequence of returns is important because it can affect the dollar value of your portfolio if you’re making contributions or withdrawals over time. In a nutshell, the periods when more dollars are invested will carry more weight in your overall results.

For investors already in retirement, that makes the first few years after retirement critically important. A negative sequence of returns can be detrimental for many years to come. For younger investors just getting started with saving, it works in reverse: The first few years carry less weight in your long-term results because your portfolio has fewer dollars to earn those returns. As your portfolio value increases over time, though, the sequence of returns becomes more important.

Let’s look at a couple of simple examples to see how this works in practice. If you invest $5,000 per year in a fund that earns 10% one year, 10% the second year, and negative 10% the third year, you’d end up with $14,895. That’s an internal rate of return of negative 0.35%--lower than the fund’s annualised return of 2.9% per year.

Sequencing risk

If the returns happen in a different order, you’d end up with different results. As shown below, the same $5,000 annual investment in fund that loses 10% the first year and then has positive returns of 10% in the second and third years ends up with a value of $16,995. Because more dollars are at work during the years when the fund had positive returns, the internal rate of return (about 6.4%) is actually higher than the fund’s total return.

Sequencing risk - different sequence

Impact on portfolio value

Investing Compass
Listen to Morningstar Australia's Investing Compass podcast
Take a deep dive into investing concepts, with practical explanations to help you invest confidently.
Investing Compass

The basic math of total returns can work in your favor if you’re a younger investor saving for retirement. Unless you’re starting out with a significant portfolio balance from an inheritance or other personal assets, negative returns early on won’t really hurt your long-term results, as shown in the table below.

Long-term portfolio value

Note: Portfolio values based on $10,000 annual contributions (not adjusted for inflation) and actual returns for the Morningstar US Market Index starting in 2000.

For an investor who started contributing $10,000 per year to an all-equity portfolio just when the market headed into a three-year downturn beginning with the tech crash in 2000, sticking with the plan would have paid off. A young investor might feel like she’s throwing good money after bad after seeing two or three years of negative results. But over time, those early negative results have less impact. By simply continuing to invest $10,000 year in and year out (not adjusted for inflation) the investor would end up with about $745,000 by age 45. Even after shifting part of the portfolio into fixed-income securities during her 30s and 40s (which would be a reasonable thing to do), she’d still have a strong start on saving for retirement.

A negative sequence of returns can be more damaging if it happens closer to retirement. The table below illustrates what would happen with the same contribution amounts but a different sequence of returns. In this example, I used actual returns for the Morningstar US Market Index from 2000 through 2020, but in reverse order. With more dollars invested right before the three-year market downturn, the investor would end up with a portfolio value of about $345,000 at age 45. That’s not terrible, but less reassuring than the total in the previous example.

Long-term portfolio value - reversed

Note: Portfolio values based on $10,000 annual contributions (not adjusted for inflation) and actual returns for the Morningstar US Market Index from 2020 to 2000 (in reverse order).

Mitigating the risk

There are a number of steps you can take to manage sequence-of-returns risk as a younger investor. Most important, don’t get too discouraged if you start contributing to a super fund right before the market heads into an extended downturn. Time is your friend, and the odds are that sticking with your plan will eventually pay off. It’s also important to keep any portfolio losses in perspective. They may be painful at the time, especially if your retirement portfolio represents all the wealth you’ve managed to build up so far. But if you’re planning for goals that are decades down the road, two or three years’ worth of early losses won’t really affect your odds of long-term success.

Checking in on your progress every few years is another wise move. Fidelity and other investment managers generally recommend setting a retirement savings target based on your age, aiming for a multiple of one times your salary by age 30, three times by age 40, and eventually 10 times by age 67. If you’re close to this target, keep doing what you’re doing. If you’re falling short, try to course-correct by boosting your savings rate as much as you can.

Adjusting your asset allocation over time also plays a critical role in keeping sequence-of-returns risk in check. If you’re in your 20s, it makes sense to heavily favour stocks. With age, though, you’ll want to adjust your portfolio mix to include more fixed-income securities, especially in the years leading up to retirement. Holding bonds as a buffer helps guard against losses in portfolio value during market downdrafts. Because equity values can take five years or more to recover from market downturns, a more-balanced portfolio allocation can help mitigate the risk of a negative sequence of returns as you approach retirement.

Sequence-of-returns risk involves a complex interplay of market returns, time, and cash inflows. For younger investors, though, it can represent both a hazard and an opportunity. Understanding how the order of when things happen can affect your portfolio value over time is an important first step toward taking control of your financial future.

is a portfolio strategist for Morningstar.

© 2021 Morningstar, Inc. All rights reserved. Neither Morningstar, its affiliates, nor the content providers guarantee the data or content contained herein to be accurate, complete or timely nor will they have any liability for its use or distribution. This information is to be used for personal, non-commercial purposes only. No reproduction is permitted without the prior written consent of Morningstar. Any general advice or 'regulated financial advice' under New Zealand law has been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), or its Authorised Representatives, and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. For more information, refer to our Financial Services Guide (AU) and Financial Advice Provider Disclosure Statement (NZ). Our publications, ratings and products should be viewed as an additional investment resource, not as your sole source of information. Morningstar’s full research reports are the source of any Morningstar Ratings and are available from Morningstar or your adviser. Past performance does not necessarily indicate a financial product's future performance. To obtain advice tailored to your situation, contact a licensed financial adviser. Some material is copyright and published under licence from ASX Operations Pty Ltd ACN 004 523 782. The article is current as at date of publication.

Email To Friend