Sequencing Risk Explained

The timing of negative returns could leave one vulnerable to Sequencing Risk, and can have a great negative impact on the value of one’s wealth at retirement. How big can this impact be? Can we quantify it? Should we bother?

Let’s take a significant event that is top of mind for most - the GFC period in 2008 when the Australian S&P/ASX200 Index fell by 41%.

We will simulate the returns of two portfolios, both with an inception amount of $100,000 for a 12-and-a-half-year period from 2008 to June 2020, but from two different starting points. One with static value (Diagram 1), and the other with yearly contributions to the portfolio in both scenarios (Diagram 2).

For each diagram, portfolio A depicts the GFC event happening early in the investment period (2008) as it was, whilst portfolio B simulates a reverse situation, where the GFC event happened at the end of the 12.5-year investment period (in Jun 2020), with all other variables remaining stable.

Diagram 1: No Sequencing Risk on portfolio with no contribution or withdrawal in 12.5 years

Diagram 1 demonstrates that where there had been no new contributions made to portfolio investment returns, there was relatively no difference between Portfolio A and B. In this case, the significant event happening at different times made no impact on the result, and there was no sequencing risk.

Diagram 2: Sequencing Risk on portfolio with 12 yearly contributions totalling $300k

On the other hand, diagram 2, simulating a superfund with regular contributions into a portfolio, showed Portfolio B (depicting the GFC occurring in 2020) underperformed by 26% compared to Portfolio A. This was not because of any investment strategies or choice of investments, but purely as a result of Sequencing Risk. The worst return happens at the worst time, at peak portfolio value. 

What are the lessons we can draw from this scenario analysis? Investment returns matter, that is a given. But how one invests early in the investing or wealth accumulation journey matters, and how one protects one’s wealth close to peak and post-accumulation matters even more.