Lowes Magazine Issue 130

INVESTMENT

How sequencing risk affects portfolios One area of concern for portfolios is what is known as sequencing risk. This is the effect of losing or taking out money from a portfolio at the wrong time. If capital is lost from an invested portfolio in the years around entering retirement, for example, it can be very difficult to recover the capital, especially in a short period of time. Think how long it has taken to build the retirement pot in the first place. This then affects how much income a person can take out of their pot if it is to last their lifetime. Taking money out to retire when prices have fallen and returns are low, means more of the portfolio needs to be drawn down to meet the desired level of retirement income. This will run down the portfolio much more rapidly than if returns were high. Then when returns improve, and the market recovers, there are fewer units left to take advantage of the rising market. This effect is compounded, meaning their prospects worsen come the next market downturn. The opposite applies if retirement begins when returns are trending upwards. Ways to help deal with sequencing risk, are first to diversify the portfolio so that if one area of the market falls, but others remain less or not affected, the rest of the portfolio can help keep the portfolio growth and/or income stream more robust. A typical way to do this was to invest in equities and bonds, which historically have been uncorrelated, so when one went down the other did not. In recent years this has not worked as well, as equities and bonds have been more correlated than is usual. However, that now seems to be reversing. Having a portfolio with a wide spread of investments, including equities and bonds, should be considered. Also important is to plan ahead. Using powerful forecasting tools, we can map out scenarios where a fall in the market happens around retirement and then factor in different levels of market impact, so we can see and plan for, those eventualities. This way we can think ahead and plan, for example, to save more than is needed for a comfortable retirement into a diversified portfolio to help mitigate against this risk, should it occur. Also, to understand that in the event of a market fall, it may be necessary to push back retirement, or to take a lower income than desired. These are areas where Lowes advisers can help, backed by our expert investment team.

Ways we assess an appropriate portfolio There are two ways to ensure the approach taken when recommending a portfolio of investment aligns with the individual client’s own feelings on investment. These are Attitude to Risk and Capacity for Loss. Attitude to Risk is an individual’s willingness to take on risk in their investment portfolio, bearing in mind that risk is more often necessary to achieve higher returns. It’s how comfortable someone feels with the level of fluctuations in the value of their investments and seeing the value of their portfolio go up and down. There are a number of tools accepted as a way to measure attitude to risk, which generally take into consideration financial goals, the length of time a person is investing, whether they need a steady income, and to what extent they feel they could tolerate losses. This information is collected early on and then reviewed along the investment journey. Younger investors may want to take more risk with their money, looking for the opportunity to maximise potential returns. Clients who are heading towards retirement will more often want to be more cautious, as wealth protection will be at the forefront of their minds. Capacity for loss is a measure of how much financial loss an individual can afford to sustain without negatively impacting their financial situation or lifestyle. Capacity for loss is a particularly useful measurement for those who are at or in retirement. At this stage in our lives, we are primarily looking to generate income from capital and if that capital declines it can affect our income stream. This is described as sequencing risk (see left). Capacity for loss takes into account factors such as income, assets, liabilities, and expenses. Our view In general, our experience is that what affects people most is not so much market volatility but rather losses to capital. What’s important to most people is to maintain capital on which they can build wealth. Our approach therefore, is to focus on helping our clients do just that.

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