Managing Sequence of Risk

bostonerimus

tacpot12 said:

To the people who pointed out that there had not really been a poor sequence of returns during the pandemic, would agree with this, but I would also point out that the nature of the risk is that we don't know whether one poor return is the start of a sequence or not.

My contention is that by taking my income from the natural yeild of the portfolio, I am less exposed to any sequence of return risk. I might have a poor return, or I might have a sequence of poor returns, but it only affects my income during  the period of the poor return, when the returns return to normal, all my assets return to normal. Someone whose plan is to sell assts for their retirement income will not have their assets return to normal as they have sold some of them (and done so at low prices, so had to sell more. I only sell when the markets have not just crashed. 

I know that this smacks of trying to time the markets, but I'm willing to risk that a recovery follows a crash.  

 

A sensible withdrawal plan should be able to survive all but the very worst combinations of historical market statistics so 95% of SORR scenarios should be baked in. But if you are really careful you can further avoid SORR with diversification of income sources. If you are using a Total Return strategy where you plan to take dividends and capital gains you have to plan for the years when you have no gains and try to avoid selling capital. That might mean drawing on your cash buffer, or just dividends and interest, or maybe selling some fixed income allocation if it hasn't fallen quite as much as equities. Annuitizing some of your pot is also away to mitigate SORR as is just reducing spending. When I looked at this problem I decided that before retirement I was going to arrange things so that I never needed to use capital gain or my saved capital. I was lucky to have the option of a DB pension and rental income, but still keep a 2 year's spending cash buffer and can always add some natural yield if needed and eventually I'll be getting SP too. 

I've planned carefully and been lucky and if you can live off dividends and interest and never sell capital then you have a very solid plan. However, many people do not have pension pots large enough to live off only natural yield.

JohnWinder

I might have a poor return, or I might have a sequence of poor returns, but it only affects my income during  the period of the poor return, ... Someone whose plan is to sell assts for their retirement income will not have their assets return to normal as they have sold some of them (and done so at low prices, so had to sell more.

That sounds like an invalid argument, in that it compares apples with pears. You're suffering reduced income during a bad SoR (with lower dividends), but you haven't allowed in your comparison that the person selling capital to fund their retirement will also choose to reduce their income and thus sell less of their assets. They don't have to sell more, as you suggest, if they choose to reduce their standard of living as you have chosen to do.

coyrls

Apart from the issue of variable income, the other issue with an income portfolio is that it inevitably restricts diversification, as it must, by definition, be composed of income generating equity and fixed income.  The lack of diversification leaves such a portfolio more exposed to risks that are specific to the type of companies that pay higher than average dividends and the type of bonds that have a higher than average yield.

masonic

tacpot12 said:

My contention is that by taking my income from the natural yeild of the portfolio, I am less exposed to any sequence of return risk. I might have a poor return, or I might have a sequence of poor returns, but it only affects my income during  the period of the poor return, when the returns return to normal, all my assets return to normal.

It really depends what could have been done with that income if it has not been paid out by the companies. If they are foregoing future growth opportunities, or weakening their financial position, then the effect could extend beyond the period of downturn and recovery. It's easiest to visualise this when thinking of the investment trusts which sometimes sell holdings to meet ambitious dividend targets, but any company is capable of an analogous practice. The reality is much more nuanced than natural yield being a free lunch.

Thrugelmir

tacpot12 said:

My contention is that by taking my income from the natural yeild of the portfolio, I am less exposed to any sequence of return risk. I might have a poor return, or I might have a sequence of poor returns, but it only affects my income during  the period of the poor return, when the returns return to normal, all my assets return to normal.

 

Individual company finance is somewhat more complex when it comes to dividends paid out. Profit is a paper number for accounting purposes. Strength of the balance sheet is more important. But free cash flow trumps them both. If the company is accumulating more debt in order to maintain or even increase the annual dividend. If future growth fails to materialise. Then the asset value of the business will stagnant or fall, resulting in underperformance compared to the wider market. Companies are not ATM machines. Like the economy. Many have cycles of up's and down's. Fortunes depending on the human management team in charge at the time. Without people a company is worth nothing. 

Audaxer

tacpot12 said:

My contention is that by taking my income from the natural yeild of the portfolio, I am less exposed to any sequence of return risk. I might have a poor return, or I might have a sequence of poor returns, but it only affects my income during  the period of the poor return, when the returns return to normal, all my assets return to normal. Someone whose plan is to sell assts for their retirement income will not have their assets return to normal as they have sold some of them (and done so at low prices, so had to sell more. I only sell when the markets have not just crashed. 

 

I like equity income funds and ITs and I can understand not wanting to sell capital in a falling market, but I am not sure you are less exposed to sequence of returns risk by taking dividends. If for example you compared the INC and ACC versions of the same fund, where the person with the INC fund took the dividend in a falling market and the person with an ACC fund sold the same percentage of capital, their resultant fund values should be the same and take the same time to recover as far as I am aware.

MK62

Audaxer said:

tacpot12 said:

My contention is that by taking my income from the natural yeild of the portfolio, I am less exposed to any sequence of return risk. I might have a poor return, or I might have a sequence of poor returns, but it only affects my income during  the period of the poor return, when the returns return to normal, all my assets return to normal. Someone whose plan is to sell assts for their retirement income will not have their assets return to normal as they have sold some of them (and done so at low prices, so had to sell more. I only sell when the markets have not just crashed. 

 

I like equity income funds and ITs and I can understand not wanting to sell capital in a falling market, but I am not sure you are less exposed to sequence of returns risk by taking dividends. If for example you compared the INC and ACC versions of the same fund, where the person with the INC fund took the dividend in a falling market and the person with an ACC fund sold the same percentage of capital, their resultant fund values should be the same and take the same time to recover as far as I am aware.

True enough, but both the share classes are invested in the same dividend producing companies.....so the returns should be the same.

You could compare a growth fund's ACC version with an income funds INC version.....but then it's apples and pears again.

MK62

tacpot12 said:

To the people who pointed out that there had not really been a poor sequence of returns during the pandemic, would agree with this, but I would also point out that the nature of the risk is that we don't know whether one poor return is the start of a sequence or not.

My contention is that by taking my income from the natural yeild of the portfolio, I am less exposed to any sequence of return risk. I might have a poor return, or I might have a sequence of poor returns, but it only affects my income during  the period of the poor return, when the returns return to normal, all my assets return to normal. Someone whose plan is to sell assts for their retirement income will not have their assets return to normal as they have sold some of them (and done so at low prices, so had to sell more. I only sell when the markets have not just crashed. 

I know that this smacks of trying to time the markets, but I'm willing to risk that a recovery follows a crash.  

 

It sounds good in theory, but as recent events have shown, relying on the natural yield of your portfolio carries it's own SORR.

Fair enough, if you are very heavy in bonds, this might have less effect, but for equities, many dividends have been slashed during the pandemic......if you have to sell assets to make up that income shortfall, you are back to square one on SORR. Investment Trusts have an advantage here of course, as they can "smooth" their payouts, but even then, the cash reserves needed to do that may not last as long as you might like.

I'm not saying that such a plan is "wrong" of course, just that it won't really avoid SORR.......

ColdIron

MK62 said:

tacpot12 said:

To the people who pointed out that there had not really been a poor sequence of returns during the pandemic, would agree with this, but I would also point out that the nature of the risk is that we don't know whether one poor return is the start of a sequence or not.

My contention is that by taking my income from the natural yeild of the portfolio, I am less exposed to any sequence of return risk. I might have a poor return, or I might have a sequence of poor returns, but it only affects my income during  the period of the poor return, when the returns return to normal, all my assets return to normal. Someone whose plan is to sell assts for their retirement income will not have their assets return to normal as they have sold some of them (and done so at low prices, so had to sell more. I only sell when the markets have not just crashed. 

I know that this smacks of trying to time the markets, but I'm willing to risk that a recovery follows a crash.  

 

but for equities, many dividends have been slashed during the pandemic

While on the face of it this might be true, in practice it hasn't materialised in a meaningful way for many. Looking at my dividends on a rolling 12 month basis since 2017 it's barely perceptible. I certainly haven't come close to considering drawing from capital

Perhaps this says more about my personal portfolio than the wider market, it's 50/50 income generating and growth, and YMMV

Thrugelmir

ColdIron said:

MK62 said:

tacpot12 said:

To the people who pointed out that there had not really been a poor sequence of returns during the pandemic, would agree with this, but I would also point out that the nature of the risk is that we don't know whether one poor return is the start of a sequence or not.

My contention is that by taking my income from the natural yeild of the portfolio, I am less exposed to any sequence of return risk. I might have a poor return, or I might have a sequence of poor returns, but it only affects my income during  the period of the poor return, when the returns return to normal, all my assets return to normal. Someone whose plan is to sell assts for their retirement income will not have their assets return to normal as they have sold some of them (and done so at low prices, so had to sell more. I only sell when the markets have not just crashed. 

I know that this smacks of trying to time the markets, but I'm willing to risk that a recovery follows a crash.  

 

but for equities, many dividends have been slashed during the pandemic

While on the face of it this might be true, in practice it hasn't materialised in a meaningful way for many. Looking at my dividends on a rolling 12 month basis since 2017 it's barely perceptible. I certainly haven't come close to considering drawing from capital

Perhaps this says more about my personal portfolio than the wider market, it's 50/50 income generating and growth, and YMMV

Are you invested in individual company shares or investment trusts though. Also recently remember more recently the legislation was changed to allow IT's to distribute dividends from capital reserves. Whereas historically only from income reserves.