Inside Money: When good returns go bad: a sequence of events

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I spent the morning worrying about inflation and the afternoon fretting about sequencing risk.

Or was it the other way around? I forget.

Whatever, the cumulative effect was negative.

Would my day have been any better if the same events had occurred in a different order?

My gut says no. But a research report I had to read last week (or was it last month) makes me question that assumption.

Published by the Financial Services Institute of Australasia (FINSIA) last October, 'Sequencing risk: a key challenge to creating sustainable retirement income' shows that the order in which stuff happens is just as important, if not more so, than the aggregate weight of the stuff itself.

Obviously, the FINSIA report is dealing with a narrow subset of 'stuff', specifically, investment returns over multiple 40-year periods during 1900-2011.

Using a whole lot of statistical jiggery-pokery ("bootstrapping", for example), the study demonstrates, amongst other things, that two individuals (same income, same contribution rate) whose portfolios might have had identical average returns over a 40-year period, could end up with vastly different retirement nest eggs depending on the sequence of returns.

For instance, the researchers ordered the returns over the 40-year period between 1972-2011 from worst to best (ascending), and then from best to worst (descending).

The ultimate portfolio size (or "terminal wealth") ranged from $17.4 million for the ascending cycle to $1.4 million for the descending.

"Merely reversing the order in which returns are experienced, 20111972 as opposed to 19722011, yields two very different accumulation outcomes: $4.0 million (19722011) and $5.4 million (20111972), a material difference of $1.4 million or around 35 per cent," the study says.

While the FINSIA report was Australian-centric, the findings have relevance for New Zealand too, particularly as the country debates a potential restructure of the KiwiSaver default investment structure.

And instead of relying on long-term aggregate fund returns, the FINSIA report argues there needs to be "a new movement in retirement saving framed around the individual uniqueness of [defined contribution] plan members..., shifting from a debate where success is framed around time-weighted metrics (risk, reward and peers) to the things that matter for investors - dollar-weighted returns."