What does the word volatility mean to you?

Ask a retiree and they will most probably say something along the lines of “uncertainty, risk and fear”. The last thing a retiree wants is uncertainty, especially after saving and investing for years to accumulate their retirement pot.

Volatility is considered a risk factor in the investment world, but it is often confused with sequence- of- returns risk.

Volatility, measured as standard deviation, is essentially the extent to which a portfolio’s returns deviate from the average over any given period of time. As a simple example, the volatility or standard deviation of the stock market will be substantially higher compared to a money market fund, where returns are more consistent.

Sequence risk, or sequence- of- returns risk on the other hand, deals with the order in which your investment returns occur. This is effected by consistently or periodically funding (or withdrawing in retirement) from your investments.

It is important to understand that volatility, when investing a lump sum for a set investment term i.e. a planned retirement date, contributes very little to the final capital amount.

Most investors saving towards retirement do not invest a single lump sum as this is not practical. Most investors can only contribute towards their retirement monthly, unless you were lucky enough to receive a large inheritance or win the lottery. Volatility therefore matters far less when saving towards retirement, what matters most is the sequence of returns.

Retirement calculators allow you enter an assumed annual return applicable to your retirement savings. This assumption is very dangerous, as returns are never that consistent. In addition to this, a small change in the assumed return has massive implications for the final capital amount achieved and is magnified as the term increases.

Mathematics will tell you that if you assume the same average return over a particular investment term, an investor who contributes monthly to his/her retirement and receives below average returns in the initial years, followed by above average returns in the later years, will achieve a greater capital lump sum at retirement.

Reason being that although market returns may be weak at the beginning of the investment term, the investor is essentially buying more units and/or shares with each monthly contribution invested, than what they would have, had the initial returns been higher. As the years’ pass, the total investment amount accumulated by consistent investing will increase the capital base. Over the long term, our biggest ally in creating wealth i.e. compound interest, will really get to work. Compounding works far better once you have accumulated a decent capital base. In addition, if this capital base is now compounding at a higher rate, the results are spectacular.

Whilst we would all enjoy large and consistent returns year after year across the investment term, before and after retirement, long term investors must realise that this is not a common occurrence. While we cannot predict future returns, short term lacklustre performance could be beneficial in the long term, assuming higher returns later on. It is when returns are weak that monthly investments should be increased to take advantage of lower prices.

When it comes to a retirement income portfolio, volatility is not your number one enemy. The main risk is once again sequence risk. Sequence risk is like Rand cost averaging in reverse – think of it as the power of compounding in reverse.

If investors had a choice, they would prefer weak returns early in the accumulation phase pre-retirement, whilst retirees on the other hand would prefer stronger returns at the outset of retirement (see below).

The risk of weak returns in the early stage of retirement seriously impacts the sustainability of income and the longevity of capital. This is true even if strong returns occur at a later stage as there is not much capital left to compound.

Worst case scenario would be if an investor experiences a large draw down early in retirement whilst drawing a monthly income. Even a temporary drop in the value can be disastrous over the long term as the set monthly income forces the sale of more shares and/or units because of a lower price. You therefore have less capital to participate in later occurring stronger returns.

As an example, below are the returns for the S&P 500 over a 20-year period from 1989 to 2008 and the same returns inverted.

Notice how the average annual returns are the same but the resulting portfolio values at the end of the term (below) are vastly different as strong positive returns occurred in the first years of the portfolio.

This example assumes that the investor was fully invested into the S&P 500 i.e. 100% equities, and by its very nature is volatile. The appropriateness of the equity weighting in the overall asset allocation however, is different for each individual investor.

Here is another example that further illustrates the point: (Both portfolio A and B draw $5000 per annum)

Source: Fidelity Investments

Once again, the average annual returns are the same but the resulting portfolio values at the end of the 25-year term are vastly different as strong positive returns occurred in the early years of portfolio B.

In summary, sequence risk is more important than volatility in retirement Controlling volatility doesn’t necessarily control sequence risk.

Whilst we cannot predict or control the sequence of returns, there are ways to help mitigate the impact:

  • Invest consistently and have a disciplined investment strategy;
  • Reassess your retirement portfolio regularly. Do not chop and change to chase historical winners. Ensure you are on track with your plan and be disciplined;
  • Work on more conservative, lower return expectations for your calculations;
  • Have flexibility in your portfolio. While retirement annuities provide great tax benefits in the year the investment is made and during its lifetime, there are other vehicles available that can add to your retirement savings;
  • Part of having flexibility is to help avoid becoming a forced seller. This is especially important when returns are weak and you need to draw the same Rand value from your portfolio. You would need to sell more shares and/or units to make up the required income, which is potentially disastrous for the longevity of your capital;
  • Diversification; and
  • Together with working longer, endeavour to draw as little income as possible in those early years of retirement.

 

Compiled by: Greg Olbe