Safety in numbers: managing the risk of predestination
Bayes professor explains the advantages of a cautious strategy to minimise sequence risk when investing for retirement.
Following market trends might be less exciting than striking out alone but its stability produces results, Professor Stephen Thomas told a masterclass at the second Bayes Alumni Forum.
Professor Thomas was explaining ‘sequence risk’ and setting out defences against it, particularly in ‘turbulent times’.
“Sequence risk is the silent risk that affects all investors yet no one talks about it. It means having the worst possible returns in the worst possible order – where the timing of returns can have a significant impact on long-term outcomes for retirement savings.”
Presenting research findings, he outlined how the timing of retirement savings returns can produce a 50 per cent difference in annual withdrawal rates.
“When you were born – something you have no control over – is one of the most important takeaway lessons as it actually pre-determines the experience you will have in your retirement. That's a frightening thought on one level. When you look at what you could have withdrawn say over the 20th century, out of the same pot of money, depending on when you start taking it out, you're looking at the difference between withdrawing, say, 4 per cent of the pot each year and 15 per cent of the pot.”
Professor Thomas illustrated this by looking at the very withdrawal options in retirement available to ex-Labour leader Jeremy Corbyn and former prime minister Theresa May, assuming their notional pension fund had been tracking the S&P 500. The difference is down to the state of the markets on their 65th birthday and reflects the eight year age gap.
In a more recent example, a person with a pension fund tracking the S&P 500 who retired amidst the market turmoil in the days following President Donald Trump’s ‘liberation day’, would have lost 20 per cent of their retirement funds.
To counter that, Professor Thomas said, investors should follow the lead of many billionaires and adopt a trend-following investment strategy – including by moving into cash when asset prices fall below their one-year average.
“Simple, rule-driven investments can lead to higher average returns and reduce volatility, ultimately allowing for higher withdrawal rates in retirement. Research findings suggest it is best to follow the S&P Index or MSCI World Index and strategically switch between stocks and cash.”
Avoid the allure of private equity, he said, not least because too many players are now focused on fundraising rather than business management. Other principles in Professor Thomas’s rules-based strategy include:
- Focus on the maximum potential loss
- Avoid excessive diversification – pointing to investment funds that had more than 100 investment assets across a range of asset classes
- Beware ‘the fear of missing out’ syndrome.
Retirement planning advisers should be providing their clients with clear advice, he said, emphasising the need for clear communication and practical approaches to investing for retirement.
The virtues of simplicity
“There’s a lot of evidence from research being published now in the US that actually you should just stick with equities and bonds, or even just equities and cash. It is a big effort to get into private assets, private equity and commodities. The marginal gain is virtually zero, and they're all expensive to trade.”
Switching between equities and bonds – or even better, cash – is the most likely way to provide ‘smooth’ returns he said, and reduce both volatility and the ‘maximum possible loss’. He cited published results for one well researched equity investment strategy using returns back to 1870 that saw the maximum loss fall from 76 per cent to 34 per cent.
“If you're willing to smooth out the big drops, you will have a rmuch higher average. Of course, it does involve switching into cash and then back into the asset, maybe once every two years – although the timing varies. Obviously, there are additional transactional costs but they have fallen dramatically over the last 20 years.”
A commercially available App is about to be released which will bring these ideas to a wider audience.
