When markets are volatile, investors need to pay close attention to the sequence of their returns, particularly if they are taking an income, CJ Cowan, income portfolio manager at Quilter Investors, has said.
“Major central banks are beginning to tighten policy to stem inflationary pressures, but this is happening at a time when economic growth is already slowing. The fear of a policy misstep is stalking markets, along with elevated geopolitical risk, and we expect further volatility in the months ahead,” Cowan said. “It is during times like this that is particularly important to think about the sequence of your returns and the risk this can present, especially if you are taking an income from your investments.
“In a market that trends upwards, selling units in a fund to generate income works just fine. But in a sideways, down trending, or particularly volatile market a different investment strategy is required.”
Table 1 illustrates just how important the sequence of returns are when an investor sells units to draw an income. If losses are experienced early on, the portfolio will be worth less than if the losses are experienced later. This is because when you sell units for income you lock in these losses, making it harder for the portfolio’s value to fully rebound. This is despite the cumulative return without withdrawals being identical in both cases.
| Table 1 | Portfolio 1 | Portfolio 2 | |||
| Year | Withdrawal | Annual returns | Annual portfolio value (£) | Annual returns | Annual portfolio value (£) |
| 0 | £100,000 | £100,000 | |||
| 1 | £5,000 | 30% | £125,000 | -20% | £75,000 |
| 2 | £5,000 | 20% | £145,000 | -15% | £58,750 |
| 3 | £5,000 | 5% | £147,250 | 5% | £56,688 |
| 4 | £5,000 | -15% | £120,163 | 20% | £63,025 |
| 5 | £5,000 | -20% | £91,130 | 30% | £76,933 |
| Cumulative return | 11% | 11% | |||
| 18% difference in year 5 portfolio value | |||||
Source: Quilter Investors. For illustration purposes only
The volatility seen in recent months is a timely reminder of how critical it is that investors seek ways to protect against this risk, Cowan says.
“Using an investment strategy that generates a natural income through dividends and bond coupon payments helps mitigate this sequencing risk. Furthermore, income is a more stable return driver than capital growth, so investors can plan their income requirements in advance while remaining invested.
“By choosing a natural yield strategy, investors will likely see their portfolio tilted towards different asset classes, regions and sectors compared to a portfolio solely investing for long-term capital growth. This will include sectors more associated with cheaper or ‘value’ segments of the market such as energy and mining. At a time of elevated commodity prices, this is a good thing.
“Having had a strong start to the year, we expect dividend paying equities to continue to perform well in the current inflationary environment. These companies pay back much of their profits to shareholders upfront, which is eminently desirable in a world where the value of those profits is being eroded by inflation.
“We anticipate financial markets will continue to be bumpy as the world emerges from the pandemic. In these conditions natural income strategies can really come into their own.”
