Sequencing Risk 2

From all of us at Chris Humphrey Private Wealth Management we wish you a happy, healthy and prosperous 2014.  This month’s Wealth Pipeline continues our discussion on mitigating sequencing risk.  Specifically, we focus on the art of investment portfolio construction and the use of absolute return/capital preservation funds, fixed interest, low correlation assets and international securities. 

Sequencing Risk

In our October Wealth Pipeline, we defined sequencing risk as the risk of receiving the worst returns in the worst order.  To illustrate the effects of sequencing risk, we explained how two investors may have the same starting portfolio balance, exactly the same average annual returns but a completely different retirement portfolio balance depending on what order those returns occurred in.  The following strategies endeavour to smooth the investment returns of an investor and hence mitigate the effect of sequencing risk.    

Absolute Return Fridge

An absolute return/capital preservation fund is a fund which invests without regard to market benchmarks.  Whereas traditional investment funds typically measure their success in terms of whether they track or outperform a key market benchmark (usually an index), absolute return funds aim to achieve outright positive returns irrespective of whether asset prices or key market indices rise or fall.  Therefore, by allocating a portion of an investor’s portfolio to these sort of funds, the investor aims to protect that portion of their portfolio from market gyrations.     

Fixed Income 

Where negative investment returns are the product of macroeconomic downward trends, fixed interest is generally a useful strategy for reducing the negative impact on the investment portfolio.  When economic growth slows, the most common response from the Reserve Bank is to cut interest rates (to stimulate economic activity through cheaper borrowing).  A cut to interest rates will result in the price of existing fixed income bonds to increase as the higher interest rate associated with existing bonds is viewed attractively by the market.  The increase in the price of bonds will help mitigate the investor’s losses which would be sustained by exposure to stocks.   

Low Correlation Assets

Another method of smoothing returns is to allocate a portion of an investor’s portfolio to low correlation assets.  That is, an investment whose value is generally not affected by movements of the stock market but rather by factors independent of the market.  A prime example is an investment with exposure to agriculture such as water rights.   

International Securities

International investments that are unhedged may help to mitigate investment losses in the event of macro-economic shocks.  The Australian dollar is regarded by many as a proxy instrument to gain exposure to growth in Asia.  Money will naturally flow back to ‘safe haven’ currencies in the event of economic shocks thus resulting in a weaker Australian dollar.  A fall in the value of the Australian dollar will result in increased value of an international investment when measured in Australian dollars.