How can clients balance investment risk alongside the need to preserve capital?
In accumulation, volatility can present opportunities to buy favoured assets at a discount. In decumulation, the reverse effect occurs, with investors at risk of being forced sellers at a time when prices are depressed.
One of the key structural challenges to manage for clients to receive a sustainable income over time is sequence of returns risk.
For example, during accumulation, if two £100,000 portfolios experience identical returns over five years but in a different order, with one experiencing the losses in the first two years, while the other suffers them towards the end of the period, both pots will end up at the same destination. In decumulation, however, the journey is much more important. If 5% income is being withdrawn each year from these portfolios, then the one that suffered losses earlier on could end up being worth roughly 22% less than its peer, purely due to pound cost ravaging and the fact there is no time to recoup these losses before more income is taken.
Therefore the destructive power of sequence of return risk could lead to quite an awkward discussion with clients if they are running out of capital and may need to consider an income holiday at the time when they need income the most. Furthermore the volatility in markets, similar to what we witnessed in the first quarter of 2018, can exacerbate sequence of return risk, which is why it is so important to manage it.
Defensive assets, including equities that have a degree of resilience to market downturns, can play a role. Likewise, derivative strategies can allow portfolio managers to capture a risk premium without owning the underlying asset, subsequently protecting in the event the asset falls in value.
Diversification provides vital insulation from the natural fluctuations of the equity market cycles, but clients also need to understand the importance of having an investment portfolio that is focused on defending capital first and foremost in order to provide them with a more sustainable and defensive source of income for their retirement.