In August I attended the annual Portfolio Construction Conference in Sydney. I try to get to this conference every year (I missed last year due to the flu) as it is a high quality event with a strong independent tone to it (no institutions flogging their products).
This year, the highlight to me was a paper from Professor Michael Drew, from Griffith University, who spoke on “sequencing risk”.
Sequencing risk is the name being given to the sequence in which investment returns are received (and not just their size).
When you receive returns is almost as important, as how much the return is, and averaging returns over long periods (e.g. you received an average return of x% pa), can mask important information. For example, a one-off drop of 10%, for somebody aged 30, with an account balance of $50,000, will amount to $5,000 and will be easily recovered by new contributions and future earnings.
By contrast, a one of drop of 10%, somebody with a balance of $500,000 and about to retire, will amount to $50,000. It will be much harder to recover and may have a big impact on retirement lifestyle.
Sequencing risk is something I have been aware of for some time, without calling it by that name and with only a general idea of its full impact.
It is great to see that the academic world now doing some work in this area. Most of the academic work around investments is based on “Modern Portfolio Theory” which emerged in the 1960’s and 1970’s. It is no longer so “modern” and is best suited to large institutions managing big amounts of money, for big numbers of people. Even then, many of its foundations have come under serious attack, especially in light of the GFC.
It is not well suited to managing portfolio on an individual basis.
The emerging work on sequencing risk is an important break with the past and is sure to produce insights that will improve our ability to provide you with quality, ongoing advice.
