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Minimising sequence risk in a mixed portfolio

Including Financial Independence and Retiring Early (FIRE)
Gilgongo
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Minimising sequence risk in a mixed portfolio

#333089

Postby Gilgongo » August 14th, 2020, 8:49 am

Am I right in thinking that a way to minimise sequence risk in retirement is to draw down on those assets that are performing the best? If so, how exactly do you determine what's "best"? Do you compare the price of the assets, say, 3 months ago and then rank them by the difference between that and today?

JohnW
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Re: Minimising sequence risk in a mixed portfolio

#333097

Postby JohnW » August 14th, 2020, 9:12 am

I wouldn’t imagine that would be the universal solution because what happened in the last three months is not a guide to what happens next.
We really need to agree on what sort of consequences we’re talking about in discussing the SoR risk. You can eliminate its effect on your portfolio by withdrawing from it the same percentage of its value each year. In a market crash of 50%, your 3% withdrawal is half the amount it was last year at 3%. Portfolio perfectly protected from decimation, just pull your belt in.
One approach is a variable percentage withdrawal strategy, higher % in the good times, lower in the bad. By adjusting the percentages as your age increases you can keep refining how much will be left when you die, to the amount you wish.
The other broad approach is ‘go back to work’. That’s no more fun than belt tightening, but the list might as well be complete.
Try this for a fuller discussion: https://earlyretirementnow.com/2017/05/ ... turn-risk/

xxd09
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Re: Minimising sequence risk in a mixed portfolio

#333100

Postby xxd09 » August 14th, 2020, 9:29 am

As a retiree and walking the walk for last 17 years
Have an Investment Plan written down
Have a set Asset Allocation
Withdraw what you need every year-keeping your Asset Allocation intact
Some years shares will be up and do the business-other years bonds
Some years a bit of both
That’s it-simple easy to understand and let’s you sleep at night
Works for me
xxd09

1nvest
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Re: Minimising sequence risk in a mixed portfolio

#333107

Postby 1nvest » August 14th, 2020, 9:53 am

Gilgongo wrote:Am I right in thinking that a way to minimise sequence risk in retirement is to draw down on those assets that are performing the best? If so, how exactly do you determine what's "best"? Do you compare the price of the assets, say, 3 months ago and then rank them by the difference between that and today?

If your preferred asset allocation is say 50/50 stock/bonds, then on the way in (accumulating) you add new money to the laggard. If bonds are at 48%, stock 52% then new money goes into bonds. On the way out (drawdown/retirement) its the opposite. If 52/48 stock/bonds then you draw your income from stocks. Those cash flows help to redirect your portfolio back towards target weightings.

That's different to SoR risk, where generally earlier years SoR is a greater risk than in later years. If for instance you were 100% stock at retirement and the next day stocks halved then you're potentially in trouble. If after 10 years the portfolio had doubled in real (after inflation) terms and stocks halved, then its nowhere near as bad.

xxd09
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Re: Minimising sequence risk in a mixed portfolio

#333191

Postby xxd09 » August 14th, 2020, 1:45 pm

Make sure well before retirement-5 years? -that you have your retirement Asset Allocation in place
The nightmare for retirees is a falling market on retiral
Depleting your portfolio at that time may mean that your portfolio never recovers!
xxd09

TahiPanasDua
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Re: Minimising sequence risk in a mixed portfolio

#333250

Postby TahiPanasDua » August 14th, 2020, 5:22 pm

xxd09 wrote:Make sure well before retirement-5 years? -that you have your retirement Asset Allocation in place
The nightmare for retirees is a falling market on retiral
Depleting your portfolio at that time may mean that your portfolio never recovers!
xxd09


xxd09,

It seems to me that financial preparations for retirement often involve 2 considerations. Firstly, will you actually have a comfortable amount to live on? Secondly, how prepared are you for real or imagined future calamities?

Estimates of both issues sometimes have as much to do with personality as hard facts. We are all different and there is no right or wrong. We try to plan for what makes us comfortable and there is inevitably a spectrum of perceived solutions. I don't think there can ever be a universal plan. I am sometimes amazed by some regular LMF posters who seem affluent but, by my standards, plan their finances as though living on tight budgets or anticipating Armageddon.

I am towards one extreme in the above spectrum. I am retired and have no bonds so no rebalancing. I live on the dividends of a highly diversified share portfolio plus a tiny pension. The virus lockdown has demonstrated, to our utter surprise, that we can exist simply but comfortably on about 1/4 of our actual income. We have about 6 years of that reduced income in cash. That's it! We will adjust our spending as things change. But this is not a suitable approach for others.

There is an age-old debate on TMF on whether one should live on natural dividend income or asset balancing.. This sounds like a simple binary choice but life and people are more complicated.

Each to their own, as they say.

TP2.

xxd09
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Re: Minimising sequence risk in a mixed portfolio

#333256

Postby xxd09 » August 14th, 2020, 5:39 pm

Interesting-as you say each to their own-there are many roads to Dublin!
Living off Dividends only always worried me but if you have a large enough portfolio and can reduce your expenses (less holidays?)-it will work
xxd09

Gilgongo
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Re: Minimising sequence risk in a mixed portfolio

#333320

Postby Gilgongo » August 14th, 2020, 10:52 pm

JohnW wrote:I wouldn’t imagine that would be the universal solution because what happened in the last three months is not a guide to what happens next.


Not sure I understand that. If SoR risk is about eroding the value of your assets too much early on by what is essentially the reverse of pound cost averaging, then what does it matter what happens next? What I'm suggesting is that at the time you need cash, you should be looking to minimise the size of the "bite" into your portfolio's units by taking that cash from the thing(s) that are up in value as opposed to the things that are down.

Thanks for the other replies from others, but things like relying on natural yield/dividends, as well as variable percentage stuff aren't what I'm asking about. They may well be nice methods, but their downsides are pretty obvious: you can't plan your spending. So, given the fact that SoR risk is seen as the number one issue in retirement (for the first 15 years or so though), I was wondering whether there was another way.

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Re: Minimising sequence risk in a mixed portfolio

#333336

Postby Itsallaguess » August 15th, 2020, 6:17 am

Gilgongo wrote:
What I'm suggesting is that at the time you need cash, you should be looking to minimise the size of the "bite" into your portfolio's units by taking that cash from the thing(s) that are up in value as opposed to the things that are down.


Sequence of Returns risk doesn't necessarily have to be solved by 100% 'non-correlated' assets though, although clearly that's one way to look at solving the problem.

The other way is to simply use a large enough cash, or near-cash, buffer to provide a source of potential 'not gone down as much' funds for those times when we might need them, and whilst it's clear that cash will 'go down' in terms of inflation whilst being held, I think it still has a part to play in helping to give some confidence to the Sequence of Returns risk that we're all (hopefully!) likely to be faced with at some point..

Whilst cash might have an element of 'opportunity cost' to it, and will also clearly be exposed to an inflation element that will slowly erode it's worth over time, I'm happy to 'pay' that price with regards to the cash element of my overall strategy, if by 'paying it', I at least gain part of the solution to this Sequence of Returns risk, and I simply see any potential 'low-level erosion losses' on it as a 'price of insurance', in just the same way as I see the cost of 'insuring' my home, and my car...

Cheers,

Itsallaguess

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Re: Minimising sequence risk in a mixed portfolio

#333338

Postby JohnW » August 15th, 2020, 6:41 am

Gilgongo wrote:Not sure I understand that. If SoR risk is about eroding the value of your assets too much early on by what is essentially the reverse of pound cost averaging, then what does it matter what happens next?

That’s a good point, and my trite answer didn’t do the subject justice.
I jumped straight to thinking: ‘you won’t solve the problem that way, but I know how to, so you’re wrong’. But you wished only to minimise the problem. So, I think your first question can be correct: draw down on the ‘least affected’. But will it always be correct?

Think your approach through:
Before the market disaster that elicits the SoR risk you are 50/50 stocks and bonds. Crash! Now you’re stocks are down 10% and bonds down 3% (or even up 3%) over the last 3 months. So you cash in bonds, a la your method. Then, bonds outperform stocks for the next 10 years such that you’d have been better off having more bonds and less stocks. The following 10 years might vindicate your choice - who knows. You can dream up any scenario to (in)validate one’s ideas - as you can see.

I think your approach is trying to identify ‘you sell whatever asset or asset class has the least upward potential in the future’; you want to keep the stuff which will go up the most. Which stuff will? No one knows how anything will perform in the future, long term or short term. Some of us think we do: study charts, look at history, do fundamental analysis, whatever. Some will turn out to assess it right, others won’t; we don’t know who is in which group until the end.

So I’ll stick by my earlier answer that your 3 month approach won’t reliably tell you which asset will perform best in the future. No doubt, in some situations it would have.

Deciding which asset to cash in during a SoR crisis is fundamentally the same as deciding what to invest your next spare cash in during stable times. You might get a better or worse return than choosing differently. No one can know ahead of time. That’s the reason people choose the ‘fixed % withdrawal/belt tightening’ or ‘go back to work’ or variable % withdrawal approaches; because they put you in control.

You can view ANY withdrawal at any time as a SoR risk issue: the markets are chugging along happily, you’re spending an asset that would otherwise have risen more beneficially at the next market upturn. So you lose out in the long term. The SoR risk we all picture occurs when markets plunge, but the same process is eroding your future wealth is you spend your assets, however the market is moving. So the SoR problem we’re trying to find an answer to is simply part of a continuum of spending/returns relationship. Those thoughts help me view solutions, which are intended to avoid the ‘no money left well before dying’ outcome, like ‘tighten your belt’ or ‘go back to work’ or ‘save more before you retire’ because they are solutions on a their own continuum which can be executed in a measure to suit the times. In contrast, the approach you suggested will be the best on only some occasions, I think.

This is one of the holy grails of draw down investing. There are complex books on it like Otar's Unveiling the retirement myth, McClung's Living off your money, and Kites' Strategies for managing sequence of returns risk in retirement.
Looking forward to hearing how you think your 3 month rule might work better than I’m picturing. Sites like portfoliovisualiser might allow back testing to see how it works.

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Re: Minimising sequence risk in a mixed portfolio

#333345

Postby Dod101 » August 15th, 2020, 8:15 am

Gilgongo wrote:Thanks for the other replies from others, but things like relying on natural yield/dividends, as well as variable percentage stuff aren't what I'm asking about. They may well be nice methods, but their downsides are pretty obvious: you can't plan your spending. So, given the fact that SoR risk is seen as the number one issue in retirement (for the first 15 years or so though), I was wondering whether there was another way.


I have been retired for 26 years and have never heard of SoR until now. SoR risk is I can assure you not the number one issue in retirement.

If you can't plan your spending you are missing an important issue; of course you can. You just need some self discipline.

You wonder whether there is another way. The other way is to live off the natural yield/dividends, making sure that you have adequate cash reserves just in case you need to call on them. You worry too much and are too caught up in investment theories. Remember, KISS.

Dod

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Re: Minimising sequence risk in a mixed portfolio

#333346

Postby Itsallaguess » August 15th, 2020, 8:24 am

Dod101 wrote:
I have been retired for 26 years and have never heard of SoR until now. SoR risk is I can assure you not the number one issue in retirement.

If you can't plan your spending you are missing an important issue; of course you can. You just need some self discipline.

You wonder whether there is another way. The other way is to live off the natural yield/dividends, making sure that you have adequate cash reserves just in case you need to call on them.


To be fair though Dod, by 'making sure that you have adequate cash reserves just in case you need to call on them', then it looks like you're actually dealing with the issue already, but just not mentally aligning your cash reserves with something *called* 'Sequence of Returns risk', but just because you're not consciously aligning your cash reserves with that risk, that's not to deny that this is the problem that you're actually solving by having those cash reserves available...you're just not giving it a name that others quite rightly want to give it....

Beyond that, of course, there will be thoughts around how to deal with things in the most optimal way for each individual investor, and I think that's where the OP is coming from, and it's a fair question to ask given the range of options available, beyond simply 'holding some spare cash'....

Cheers,

Itsallaguess

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Re: Minimising sequence risk in a mixed portfolio

#333348

Postby Dod101 » August 15th, 2020, 8:42 am

IAAG

If the investor already has a 'mixed' portfolio (by which I assume he means a diversified one) he is already more than halfway to removing the risk as best he can anyway. By the sound of it he just needs to add some cash or other reserves and job done!. No need to get caught up in investment theories, many of which are promoting common sense ideas dressed up in academic gobbledegook. I have no time for these, in any sense of the expression.

Keep it simple.

Dod

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Re: Minimising sequence risk in a mixed portfolio

#333350

Postby Itsallaguess » August 15th, 2020, 8:56 am

Dod101 wrote:
If the investor already has a 'mixed' portfolio (by which I assume he means a diversified one) he is already more than halfway to removing the risk as best he can anyway. By the sound of it he just needs to add some cash or other reserves and job done!. No need to get caught up in investment theories, many of which are promoting common sense ideas dressed up in academic gobbledegook. I have no time for these, in any sense of the expression.

Keep it simple.


No issues from me on the 'Keep it simple' front Dod, as I agree with you that a number of years worth of cash funds can adequately solve much of this risk in a fairly simple way, but my initial reply was really in response to you suggesting that Sequence of Returns risk isn't much of an issue, when at the same time highlighting that you've got a cash reserve to actually help solve the problem...

I agree that we can get sucked down rabbit holes trying to solve these problems to the nth-degree, but that doesn't detract from the fact that it's a real risk that can be solved in a number of ways, and as that is the case, then of course it's right for people to wish to explore those methods to see what suits them best...

Who knows - even those of us that have what we might think are 'simple plans' to cope with this issue at the moment, might learn of equally 'simple plans' that might deliver better long-term results, and I'm certainly 'all ears' with these types of discussions, to see if I can learn anything in that respect...

Cheers,

Itsallaguess

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Re: Minimising sequence risk in a mixed portfolio

#333372

Postby Wuffle » August 15th, 2020, 10:12 am

I know it isn't in the spirit of these boards but can't you de-risk by buying an annuity here and there.
Thereby transferring some risk to the other side of the 'how long will I live?' equation.

W.

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Re: Minimising sequence risk in a mixed portfolio

#333397

Postby JohnW » August 15th, 2020, 11:50 am

Yes, I think you can benefit from a lifetime annuity. Unless the provider goes out of business your payments are certain.
But for some people it still might mean cat food for life, because with long term interest rates low now the provider will be getting very little return on the money you give them now, unless they risk it on something that returns them more. As well, some providers need to make a profit for shareholders, so less you get. Many folk think they'd do better investing it themselves. Who knows which approach is better?

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Re: Minimising sequence risk in a mixed portfolio

#333412

Postby Gilgongo » August 15th, 2020, 12:53 pm

JohnW wrote:Deciding which asset to cash in during a SoR crisis is fundamentally the same as deciding what to invest your next spare cash in during stable times.


I'm going to have to disagree with that. When you're in the build phase, you have a choice about whether to buy at any given time or keep your powder dry. My question is about the drawdown phase: if you have bills to pay or food to eat, you can't simply decide not to pay them or not to eat :-) This is why I asked what does it matter if, for example, you draw down on the asset that has done better than another over the same time and then see the same class tank later on? The point is that you have taken a smaller "bite" out of your overall portfolio at that time than you would have done had you just liquidated at an even rate, thereby mitigating SoR risk. And as to having a cash buffer (let's say it's two years income) - where does that cash come from? Realising cash in retirement is surely subject to SoR risk as well, no? BTW I was assuming my "sell the winners" strategy would also involve re-balancing, so along with drawing down cash from winners, you'd need to feed some (current) losers in anticipation of the markets swinging the other way in the future. Others on this thread have mentioned asset allocation and diversity too, and I'm certainly conscious of those things.

But no matter. I don't think anyone here has pointed out a fundamental flaw with this plan so I'm happy with that.

On the subject of KISS - I think any "system" that you yourself operate appears to you to be simple, while others are always complicated or weird. This may just be human (investment) nature. Personally, I don't see what I'm suggesting as complicated at all compared to what others describe. I guess the only possible issue is having to record (or source) historic prices, but that's hardly much of an issue! After that it's just pick a "pay day" (I'm going for every quarter at the moment, but it could just be once a year), sort by best performing and top-slice those while keeping an eye on asset allocation and re-balance once in a while, as others have said.

A couple of footnotes:

On annuities: yes, these help to solve the problem (in fact my own calculations rely on the state pension to provide a stable "floor" on which the volatility of my portfolio can dance). But have you seen the rates these days? :-)

The above two points reminds me of the fact that I will be one of the first retirees to be forced to rely almost entirely on the markets for my existence in retirement. We have no final salary or lump-sum pensions. Annuity rates are literally half or less of what they were before 2008 (and will at this rate go even lower, and certainly never recover). The days of KISS in retirement ended in 2014 with Pension Freedoms.

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Re: Minimising sequence risk in a mixed portfolio

#333417

Postby tikunetih » August 15th, 2020, 1:08 pm

Gilgongo wrote:The above two points reminds me of the fact that I will be one of the first retirees to be forced to rely almost entirely on the markets for my existence in retirement.


I've been living entirely off an investment portfolio for nearly 20 years.

I keep a lump of cash with the rest "invested", with the cash funding my spending. Every so often I top-up the cash from asset sales, selling down overweight positions to return them to target allocations.

Not massively complicated!

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Re: Minimising sequence risk in a mixed portfolio

#333431

Postby Dod101 » August 15th, 2020, 2:09 pm

Gilgongo wrote:
The above two points reminds me of the fact that I will be one of the first retirees to be forced to rely almost entirely on the markets for my existence in retirement. We have no final salary or lump-sum pensions. Annuity rates are literally half or less of what they were before 2008 (and will at this rate go even lower, and certainly never recover). The days of KISS in retirement ended in 2014 with Pension Freedoms.


My dear friend, I retired on 31 December 1994 with a very modest personal pension in the form of two life insurance contracts not worth a lot and a substantial lump sum from overseas employment. No final salary or other pension arrangement. Apart from the State pension which kicked in a few years ago (and which I do not use; it is my travel fund) I am totally dependent on my investments to generate a retirement income. As to where the cash back up comes from, it was part of my basic asset allocation which I set at the outset, and which I have never used to live off. It is for discretionary spending, usually in the form of a new car every few years. Once you have got that sort of investment system in place, it is simple. I have two portfolios, run as one, but mentally separate so that one is the main income generator and the other the growth generator, the idea being that I top some of the growth shares from time to time and buy more income generating shares with the cash raised.

Nope KISS is the only way to go. People genuinely worry too much or try to live beyond their financial ability. I have known a few of these over the years. I live in a nice area with a new car every few years and foreign holidays annually (when we do not have an international pandemic.) It is not difficult and I have never heard of sequence risk until today.

Dod

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Re: Minimising sequence risk in a mixed portfolio

#333462

Postby TheRIT » August 15th, 2020, 5:33 pm

Dod101 wrote:...or try to live beyond their financial ability. ...

This is a critical point and as somebody who has had plenty of years in living a self funded retirement your experience (both psychological and mechanical) is invaluable to us "newbies". Would you be prepared to share in % terms what annual income to assets ratio you started with at the end of 1994 and what that % looks like today?

Looking back the end of 1994 was a very good time to retire. Using US data as a proxy with 80% equities, 15% bonds and 5% cash with a starting drawdown of 4% increasing by inflation annually shows wealth will have grown by nearly x3 in real terms. Anybody who started spending within their financial ability and who hasn't ramped spending significantly above inflation in retirement under that scenerio will be now spending a tiny percentage of their wealth. I'd guess your wealth, in real terms, has never fallen below what your retired with. A very different story to someone retiring in say the mid-60's which is to date one of the worst historic times to retire from a sequence of returns perspective.

Personally, I started with 3 years in cash plus spending 85% of my dividends with the remaining 15% going to cash. In the bear times I'll draw down on the cash and in the bull times I'll top up the cash with the 15%. In % terms when I first FIRE'd that scenario was an annual income to assets ratio of about 2%.


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