We need a bigger rise in value to return us to where we started.
This effect is even more significant if clients have to withdraw money from the portfolio after it has fallen. A 10 per cent fall requires an 11 per cent rise to return a portfolio to its starting point, but if a withdrawal of 5 per cent of the portfolio’s starting value is taken after the fall, then clients need an 18 per cent rise to get back to the starting point.
Any withdrawal of a constant cash amount, or a constant percentage based on the portfolio’s starting value, will affect the portfolio more if it has fallen in value. A greater number of units will need to be sold to generate the required amount of cash.
This reduces the amount of capital that is left to grow when the market rises, lessening the likelihood that the portfolio will recover to its previous level. This thief is pound cost ravaging.
Investors tend to be more familiar with its more generous twin pound cost averaging, which is a helpful influence in the accumulation phase. A regular cash sum invested buys more units after a market fall, boosting returns when the market recovers.
However, in the decumulation phase pound cost ravaging can make a moderate drawdown into a serious threat to an investor’s long-term objectives.
If possible it is best to avoid taking withdrawals from a portfolio of risky assets after a significant fall, but many investors will not have that degree of flexibility.
It is not only the magnitude of a market fall that determines its impact on a decumulation portfolio. Just the order in which the returns occur can have a dramatic impact.
Two decumulation portfolios with identical annual returns except for a single year of market falls will have a dramatically lower value after 10 years if the fall takes place in year one, as opposed to year 10.
The reduction in portfolio value is not just a bad thing in itself. It also limits the portfolio’s ability to sustain the investor’s required level of yield. If the same rate of withdrawal continued then the portfolio which had the fall in year one would be exhausted after 19 years, whereas the one which had its fall in year 10 would last for 27 years.
Sequencing risk is at its most dangerous when the portfolio value is at its highest, around the point of retirement. This is the time when a market drawdown can have the greatest impact on the portfolio’s long-term value.
Inflation bites
Inflation is more subtle, but highly pernicious. Theoretical physicist Albert Einstein reportedly stated that compound interest is the most powerful force in nature.
