Sequencing Risk – October 2018 AF4 Past Paper Question Review

Sequencing risk

Most financial planners have heard of the term. A number could give a fairly decent attempt at an explanation of it. Could you answer a ten mark exam question on it?

That’s a slight exaggeration in this instance as the question in the October 2018 paper was only worth 5 marks (interestingly, it also turned up in the AF7 paper at the same point). But the point could easily be laboured for a few extra marks.

The examiner’s guide stated:

‘Sequencing risk was introduced into the paper for the first time as it is an increasing relevant topic and is moving into the mainstream of investment planning. Many candidates gave superficial explanations that suggest they know of the term but do not know how it operates, often confusing it with an explanation of market movements or phased investment into a market’.

So what exactly is sequencing risk?

In its simplest form, where an investment is left untouched for several years, it will usually show a profit. In those times, there will have been peaks and troughs, but the key factor is that it does not matter in which order the returns have arisen. In other words, if you gain 10% then lose 5%, or vice-versa, it doesn’t really matter. The end result is still the same.

Sequencing risk arises where you are taking withdrawals from a portfolio and is a variant of pound-cost ravaging. Where a consistent level of withdrawal is being taken, more units will be sold when the price is low than when it is high. That means that the impact of some bad returns early on, even if the market makes them up later, will be more pronounced than if the sequence of returns was reversed.

Example

Let’s consider two funds with a £100,000 opening value and a £20,000 first year withdrawal. You will note that the actual returns on these portfolios are identical, but the sequence is reversed.

Fund A

Year Opening value Returns Withdrawals Closing value
1 £100,000 -15% -£20,000 £65,000
2 £65,000 -10% £0 £58,500
3 £58,500 20% £0 £70,200
4 £70,200 12% £0 £78,624
5 £78,624 5% £0 £82,555.20
6 £82,555.20 6% £0 £87,508.51
7 £87,508.51 2% £0 £89,258.68
8 £89,258.68 7% £0 £95,506.79
9 £95,506.79 4% £0 £99,327.06
10 £99,327.06 6% £0 £105,286.69

Fund B

Year Opening value Returns Withdrawals Closing value
1 £100,000 6% -£20,000 £86,000
2 £106,000 4% £0 £89,440
3 £110,240 7% £0 £95,700.80
4 £117,956.80 2% £0 £97,614.82
5 £120,315.94 6% £0 £103,471.70
6 £127,534.89 5% £0 £108,645.29
7 £133,911.64 12% £0 £121,682.73
8 £149,981.03 20% £0 £146,019.27
9 £179,977.24 -10% £0 £131,417.34
10 £161,979.52 -15% £0 £111,704.74

You will see that there is quite a significant difference between the end figure in the two calculations. This is the main basis of sequencing risk, depending on the sequence in which the returns transpire, the impact of a withdrawal can be magnified significantly.

Conclusion

The CII are somewhat brief with their model answer. But it’s worth studying and that’s the basic principle. Sequencing risk relates to the impact on long term returns generated whilst taking withdrawals from a fund which arises from negative returns and the resulting sale of a higher number of units in the early years.