• Darren Burns

Can we (really) time the market? (Part 3 of 3)

The first two parts of this article outlined the additional risks investors face as they approach retirement. Importantly, these risks originate from volatility in the market. As we all know this is highly unpredictable. As a reminder, life cycle risk is the risk of significant market underperformance in the final years leading up to retirement, when investors’ contributions are at their highest levels. Sequence risk, on the other hand, is the risk that the timing of drawdowns from retirement savings can negatively affect the overall longevity of the investment. Before we conclude on how to mitigate these dangers, there is one other risk that can only be addressed by the investors themselves. Unfortunately, there is no special investment product nor prevailing investment plan that can alleviate the threat of longevity risk.

Longevity risk

Traditionally longevity risk refers to the chance that life expectancies and actual survival rates exceed expectations or pricing assumptions, resulting in greater-than-anticipated cash-flow needs on the part of insurance companies or pension funds. For individuals, it is simply the risk of outliving one's assets and running out of capital during retirement. There have been many articles that speak to this topic, so I will reiterate the collective opinion: save… and when you think you have saved enough – save some more.

The Glacier by Sanlam guidelines reveal that individuals aged 65 should not withdraw more than 5% of their income per annum, in order to keep up with inflation and not outlive their capital. If we assume that this number is a reality for most investors, the existing risk of being in the market can still be alleviated.

Life cycle risk

Unfortunately, there is no unified or all-in-one solution that can eliminate all risks at the same time as retaining the full upside of a risk-on investment portfolio. The result is that planning a successful financial future becomes a delicate balancing act between risk and reward. Individuals often associate taking risk off the table as simply reducing their potential future growth. However, with a glass-half-full mindset reducing risk can be seen as increasing the certainty of future outcomes.

So, in the real world, how do we use this thought process to address life cycle risk? The simple answer is – gradually reduce the risk in your portfolio the closer you get to retirement. The exact point at which investors begin this process and at what rate, is rather personal. While different investors require different levels of income to subsist, the straightforward notion is to increase certainty as life becomes more uncertain.

Life stage models, which generally have a more absolute-return focus, are comprehensive solutions that effectively remove the manual process of reducing risk as investors near retirement. These plans may not be exactly tailored to each investor’s personal needs, but they do provide a good starting point.

To illustrate this, please see the graph below. The red line is the outcome for the investor in Part 1 of this article, who retired in 2019. The blue line is the outcome for the same investor who introduced a life stage model and gradually reduced risk prior to retirement. While the life stage investor did enjoy marginal outperformance, the primary benefit was the reduced volatility and significant increase in certainty with regards to their final investment value.

Many studies have proven that the emotionally negative effects of losing money far outweigh the same positive outcome and I believe that most investors, given a choice, would happily give up a measure of potential upside performance for the security in knowing that their investment would be there for them when they need it most.

Sequence risk

As identified in Part 2 of this article, sequence risk can drastically affect the value of an investor’s portfolio dependent on the level of volatility experienced in the early stages of withdrawal. As mentioned, the culprit is volatility of returns. Given this, the natural solution is to reduce volatility and create certainty that these reduced levels of volatility will provide a consistent return that can sustain an income.