By Tim Courtney, Chief Investment Officer
Every investment carries risk, even if we don’t always acknowledge it. It is easy to recognize risk in certain assets, such as a company that's not profitable with a slight prospect of growth. Investors in such a company could face default risk and illiquidity risk among others.
On the other hand, what if we bought a simple Treasury bond? Even with a highly rated bond backed by the tax collections of the U.S. government, risk exists. Over the past several years, we’ve witnessed firsthand the impact of inflation risk. Treasury returns over the past decade have not kept up with the rate of inflation. Treasuries also contain interest rate risk which causes prices to fall as rates increase.
Every asset has a risk associated with it. In addition to asset level risks, there are also portfolio-level risks. One of these is timing risk, similar to what is often called sequence of returns risk. For example, consider an investor who finds himself needing to sell an asset in order to generate cash flow for an unexpected expense. Let’s say this occurred in 2022—a year where stock indexes were down approximately 20% and bond indexes down over 10%.1 The investor who needed to sell stocks or bonds then faced the risk of having to sell an asset at an inopportune time.
Planning for this risk is crucial because it can, and for some investors does, lead to the realization of the ultimate risk of depletion, where a portfolio tips over as withdrawals become larger than annual growth. While we can’t eliminate these risks, we can address them and attempt to balance them.
Let's explore sequence of return risk further. Suppose the stock market averages an 8% annual return over the next 30 years. While we might plan for a consistent 8% return each year, we know markets don’t work this way. Some years may see a 30% gain, others a 30% loss. On average, the market returns 8%, but the path to that average is unpredictable. The path or sequence of returns aren’t a concern if you never take distributions from your portfolio or sell any assets over those 30 years.
However, sequence of return/timing risk does come into play when you start to make withdrawals from your portfolio. If timing works against you, your actual return (IRR) may be much lower than 8%. Because of this risk, we work with clients to create a withdrawal strategy. The first line of defense to address this risk is having a diversified and properly weighted portfolio so that you have multiple types of assets to sell. These assets shouldn’t behave in the same way, especially when broad market indexes are falling.
This aligns with our philosophy of being accommodating investors. When selling assets, we want to give the market what it wants. By diversifying, we increase the likelihood that we own an asset that the market demands, whether it be a growth or value stock, small cap or international stock, or commodity or real estate. For instance, in 2022, the market rejected growth stocks and long-term bonds, so it would make sense then to give the market what it valued more: short-term bonds and value stocks. Alongside building a portfolio, we must establish a withdrawal strategy and know which assets we will be withdrawing from under different market scenarios.
Unfortunately, there are risks that we must take to capture returns. But we can manage and balance these risks to improve outcomes. As accommodating investors, we maintain diversified portfolios and have withdrawal strategies in place to make sure we can sell to the market what it wants and conversely buy assets the market is willing to sell at discounts. If you have a question about your withdrawal strategy, please contact your Exencial advisor.
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Internal rate of return (IRR) is a financial metric used to estimate the profitability of a potential investment. IRR is found by identifying the discount rate that makes the net present value (NPV) of all cash flows from an investment equal to zero. NPV is the difference between the present value of cash inflows and the present value of cash outflows over a period of time.