by Corey Hoffstein, Newfound Research
- We’re often asked, “is now a good time to implement tactical strategies?”
- We believe there are better and worse periods for tactical, largely based upon expected risk/reward trade-offs and available diversification opportunities.
- For investors, we believe an equally important consideration is where they are in their investment lifecycle trajectory. For investors with longer horizons, the potential costs of tactical strategies may not make sense, except in extreme capital market scenarios.
- Specifically, we believe that investors should most actively seek to manage risk when they are most susceptible to sequence-of-return risk. In this commentary, we seek to identify exactly when that is.
As a tactical manager, one of the questions we often receive is, “is now a good time for tactical?” With many investors concerned about both high equity valuations and low interest rates, tactical strategies seem like a natural way to “protect and participate.”
Our response to this question is, “for whom?”
We’re of the view that tactical is not for everybody, nor is it necessary in all periods of an investor’s lifecycle. Rather, tactical makes the most sense, in our opinion, when sequence risk is highest and when traditional forms of risk management are expensive. What is sequence risk and when does it peak?
Most individual investors follow the same, broad investment life cycle. In their early years, they have little investment capital and a lot of human capital. Over time, they transform their human capital – through income earned and savings – into investment capital. At some point, they deplete their human capital (i.e. retire) and then spend the rest of their life living off of their investment capital.
And, if planned correctly and with a bit of luck, the investment capital outlives the investor.
While many of the variables in the retirement equation can be influenced by the investor (e.g. savings rate and withdrawal rates), some – like the market return – are entirely out of their control.
Worse, the actual sequence of returns – not just the long-term rate – can have a material impact on an investor’s experience. A 50% portfolio loss the year before an investor retires will have a large effect upon their safe withdrawal rate, and therefore the lifestyle they can afford to lead. That is sequence risk.
But sequence risk is not a constant throughout an investor’s lifecycle. Understanding when sequence risk peaks may be critical for establishing optimal financial plans in the future.
To get an understanding of when sequence risk peaks, we will simulate an investor’s investment lifecycle.
Specifically, we will assume an investor who starts saving at age 21 and retires at age 65. We’ll make a number of other assumptions about salary, savings rate, withdrawal amounts, et cetera; all of which we will keep constant across simulations.
To establish when sequence risk has the greatest impact, we will run 7,900,000 simulations (79 years x 100,000 simulations). For each simulation, from age 21 to age 100, we will assume a constant rate of portfolio return. Except for one randomly selected year, for which we will inject some volatility by randomly drawing a return for that year.
Given each simulation’s sequence of market returns, we will then calculate the age at which the investor ultimately runs out of money.
Finally, for each year between age 21 and 100, we then accumulate all the simulations that shocked that specific year and calculate the minimum, average, and maximum age when the investor ran out of money.