Developing a Measure of Sequence Risk
27 Pages Posted: 27 Jan 2020
Date Written: December 27, 2019
We discuss the nature and importance of the concept of Sequence Risk, the risk that a bad return occurs at a particularly unfortunate time, such as around the point of maximum accumulation or the start of decumulation. This is especially relevant in the context of retirement savings, where the implications for withdrawal rates of a bad return can be particularly severe. We show how the popular ‘glidepath’ or target date savings’ products are very exposed to such risk. Three different measures of Sequence Risk are proposed, each of which is intended to inform investors of the probability that a chosen investment strategy may not deliver desired withdrawal rates and hence these measures are intended to aid investment choices; conventional performance measures such as Sharpe or Sortino ratios are only indirectly related to this ability to achieve a given withdrawal experience. Finally, we note that, using US data, very simple portfolios comprising equities and bonds can achieve very low probabilities of failure to achieve popular desired withdrawal rates such as 5% p.a. providing the equity component is ‘smoothed’ by switching in and out of cash using a simple trend following rule.
Keywords: Glidepath Investing, Sequence Risk, Perfect Withdrawal Rates, Trend Following
JEL Classification: G10, G11
Suggested Citation: Suggested Citation