This Is One Of The Biggest Risks To Your Financial Freedom - And You’ve Probably Never Heard Of It

You know about investment risk. You understand the concept that by investing into something, you’re putting your money at risk in order for the potential to generate returns. Low-risk places for you cash, like bank accounts, offer poor returns but with no volatility (but not no risk, because inflation is going to slowly eat away at that capital, see our full breakdown here).

VC’s and angel investors take huge risks with their money, expecting a small number of their bets to generate outsized returns while understanding they’ll probably lose the rest or barely break even.

You probably know about concentration risk, and why spreading and diversifying your investments limits the chance that the failure of a single company or asset will put your portfolio into the red.

With everything that’s gone on with Silicon Valley Bank, you might even know about interest rate risk. That is, the impact that rising or falling interest rates can have on the market and asset prices. Particularly the bond markets.

But there’s one form of risk you almost certainly haven’t heard of. And it could be one of the most important to your plans for financial freedom or early retirement.

Sequencing risk.

Key concept: Recovery from loss isn’t linear

Don’t worry, we’re going to explain exactly what sequencing risk is and how to navigate it. But first, there’s a key concept that we need to cover. Honestly, it’s really very simple, but when it comes to investing, most don’t connect the dots.

When you make a certain percentage loss on an investment, you need to gain a significantly higher percentage to earn those losses back. 

That probably makes little to no sense, so let's go through a brief example. Say you’ve invested into a high-risk investment that has the potential for big gains, but the potential for major volatility as well.

You invest £100,000 and over the course of the first year, you suffer a loss of 40% on your initial capital. The next year, the asset rebounds and generates a return of +40%.

Amazing! A loss of 40% in year 1 and a gain of 40% in year 2 means you should be back even at least, right?

Wrong.

It’s one of those quirky number riddles that seems one way when the reality is quite different. Let's walk through the details on this.

40% of £100,000 is £40,000, so in year 1 your portfolio drops from £100,000 down to £60,000.

£100,000 x 40% = £40,000

The next year you gain 40%, but because your portfolio is now only worth £60,000 that gain equates to a pound value of £24,000. That brings your portfolio value up to £84,000.

£60,000 x 40% = £24,000

Actually, in order to gain back the original loss on your £100,000 you would need to generate a return of 66.67%.

£60,000 x 66.67% = £40,002

Pretty obvious, right? Yes, but you’d be surprised how a simple concept like this gets glossed over by even sophisticated investors and market pundits.

How does sequencing risk work?

Right, so now that we’ve covered that concept we can move on to sequencing risk. What this comes down to is the order in which you achieve your returns. Over the course of a 30-year investment horizon, two investors could have identical average returns, but depending on the timing of the up and down years, very different actual financial results.

Sequencing risk is the risk that you’ll experience negative returns in your early years.

To be clear, there’s no way to know when you’re going to experience good years and when you’re going to experience bad years. Sequencing risk is something that all investors just have to accept to a certain degree.

Except for one specific group of people. Those who are in drawdown, using their assets to fund their living costs, i.e. after you achieved financial freedom or decided to retire. 

Because this is where a slight investment bump in the road can turn into a real destructive wealth event.

Going back to our example above, the 40% loss in year one isn’t ideal, but given the risk profile of it, you’d expect that over time it would generate sizable returns. If the average return over a 10-year period is, say 12%, then it’s still a very good result regardless of the volatility or the sequencing risk.

But what if you were drawing down on that portfolio to fund your living costs? As well as dropping 40% in value, maybe you withdrew an additional £10,000 to pay for a holiday. Now you not only need outsized returns to recover the loss, but also to cover your withdrawals.

That level of volatility might seem unrealistic, but the truth is that markets experience fluctuations like that regularly. It’s the issue that faces all those living off their investments, i.e. people have reached financial freedom and no longer work for money.

Negative returns in the early years of a drawdown plan are where sequencing risk really becomes an issue to be aware of. It can create a downward spiral that may not be possible to recover from, permanently reducing your standard of living.

Case Study: Jasper vs Olivia

Imagine we had two investors who’d had a decent exit from their business and decided that they wanted to cut back their working hours, focus on passion projects and not so much about their immediate financial position.

They’ve amassed a couple of million pounds, they buy a house in cash for £1.3 million, use £150,000 for angel investments, keep £50,000 in cash and then have £1,000,000 left over for long-term investments.

It’s this £1,000,000 that they plan to use to help supplement their income over the next 20 or so years. 

Both Jasper and Olivia are aged 40, and they withdraw £40,000 from their portfolio each year which helps supplement the income they receive from various other streams that they’re working on.

Jasper has some bad luck, and the first three years of his investments he notches an average annual return of -8%. Olivia has better fortune, picking up a +7% average annual return over those three years.

All the while, both of them continue to take £40,000 from their portfolios. 

The next three years the situation reverses. Olivia’s portfolio takes a hit, averaging -8% per year, while Jaspers results significantly improve, averaging 7% per year over the three-year period.

After that initial six years, both Jasper and Olivia manage to achieve an annual return of 7%. 

So it looks something like this:

Fast forward to age 65, and both of them have achieved an average annual return of 5.27% from when they were 40 until now, and they’ve continued to draw down £40,000 each year to supplement their income.

So what has that slight change in the sequence of returns done to their portfolio values at age 65?

Jasper: £999,421

Olivia: £1,192,406

Not so insignificant. So what can you do about it?

How to protect yourself against sequencing risk

When it comes down to it there are two things you can do to insulate yourself against sequencing risk. You won’t ever be able to time your investment perfectly, regardless of what the 22 year old TikTok gurus tell you. So volatility is going to happen and it might happen early in your investment journey.

Investing early

This is the first important step to turning sequencing risk into a non-issue. The less time there is between when you start investing to when you want to start drawing down on your funds, the more impact sequencing risk can have.

What that means is that you should start to invest as early as you can afford to. It doesn’t need to be a large amount to begin with if you don't have the cash available. It doesn’t have to be a lump sum, it could instead be a regular contribution from surplus cash flow each month.

The important thing is that you start. The earlier you begin to invest and generate returns, the longer that money has to grow and the bigger buffer you’ll accumulate when the bad years come. If you do happen to have a poor start on your investment journey, starting early means you’ll have more years to earn back those returns.

If you have a long term investment time frame and you’re sitting on the fence about putting your cash to work, get off it now.

Cash buffer

This is less important if you’re 10+ years away from drawing down on your funds, but vitally important if you’re planning to start withdrawals in the next 2-3 years.

A cash buffer provides you with access to short-term cash if your investments underperform. When you’re earning an income and actively growing your assets, you don’t generally want more than 3-6 months living costs. Having too much in cash limits your potential returns and sees inflation eat away at your savings.

But when you’re in drawdown, it makes sense to increase this to around 2 years worth of living costs. This way, if your portfolio does suffer a negative return early in your retirement, you’ve got other assets you can access to cover your living costs.

While we’re saying cash here, it doesn’t have to be (and probably shouldn’t be) actual cash in the bank. Cash-based investment assets or fixed-return products can work just as well here too.

The takeaway

So sequencing risk is something you might not have heard much about before, but it’s something that investors should be keenly aware of. Most of our clients and readers aren’t anywhere near retirement just yet, so the most important point to takeaway is to start investing as early as possible.

The earlier you start, the less impact a poor start will have in the end, and the more time you have to earn back any losses that might occur.

Whether you’ve got a lump sum of cash to invest, or simply some spare cash each month, getting it working for you early is going to put you in the best long term position.

Want to seem smart to your friends and colleagues while helping them out at the same time? Send ‘em this article. We can almost guarantee they’ve never heard of sequencing risk before.

And if you want to work with a company that stays ahead of the curve with things like this, book a call with Rosecut.