Unexpected inspiration from Mary Berry for income investors
For the seventh season, Mary Berry has us all glued to our TV screens watching the second (after the Olympics) most important competitive event of the year – the Great British Bake Off (GBBO). Mary has always highlighted the importance of sequencing to producing a good bake; something that income-focused investors should also pay close attention to if they are looking for more certainty around their investment outcomes.
Nowhere else is the sequence as critical as in baking.
That’s according to Mary Berry and the contestants know it all too well. Get your order wrong and your Viennese whirls may lose definition by the time they land in front of Paul and Mary. Get it right and you get the chance to bask in the glory of being crowned the Star Baker while your devastated fellow bakers look on.
What Mary tries to teach us is in essence the sequencing risk – the sensitivity of your outcome to the sequence of events leading to it.
It’s a term many financial advisors are very familiar with, especially those focused on generating income from their investments. In particular, what's also known as pound cost ravaging or path-dependency risk refers to the impact that the ‘path’ or the ‘sequence’ of market returns might have on the pot size at the end of the investment horizon.
However, unlike the relatively controlled environment of the Bake Off tent, the investment world rarely allows investors to control the order in which market returns unfold. Even with fairly accurate medium or long-term return forecasts, predicting the path that’s going to take us there is much more challenging. Hence, it is much more about managing that risk rather than removing it altogether.
If the investor is interested in receiving a regular stream of income from their portfolio, they can either opt for fixed withdrawals or natural income distributions. In the first case, they would withdraw a fixed amount from their portfolio. In the second one they would only collect whatever income is available in a given period (in terms of dividends or coupons). Interestingly, investment outcomes can be very different under these two scenarios even when the fixed withdrawal is aligned with the average realised yield on the investments over the investment horizon.
This is all because of the impact of the sequence of returns.
If you invest right before the market downturn and keep withdrawing a fixed amount every year, as your investment pot shrinks with negative market returns you may run the risk of drawing down your entire portfolio, giving up any chance of recovery when the market turns. If you opt for natural income distributions you will effectively collect lower distributions on the way down, protecting the size of your pot, and you could be rewarded with higher distributions when the market rallies, effectively participating in the recovery.
It sounds like a sensible risk management mechanism yet some still dismiss it as a purely theoretical concept that doesn’t materially impact clients’ wealth.
So we put it to the test!
Using annual UK equity returns and dividend yields, we could calculate the total end value (final pot size plus the sum of all annual distributions) for a hypothetical investment of hundred thousand pounds. In order to see if there is a difference between fixed withdrawals or natural income distributions, we then randomly reshuffled the order of these returns 10,000 times so that the sequence of these returns was different in each case. We set the fixed withdrawal at £3600 per annum (in line with the average dividend yield over the entire period we looked at).
Still, that sequence alone happened to have a tremendous impact on the investor’s outcomes as shown by our test results:
It is evident that under the natural income scenario, the distribution of outcomes is narrower, reflecting lower sensitivity to the path that equities took over the period. In contrast the fixed return scenario saw the distribution of final outcomes in the range of £300,000 – a significant dispersion given the initial investment of £100,000.
This is because the natural income essentially acts like a buffer. In weak markets, it limits the withdrawals to keep the pot large enough to benefit from the future recovery. In strong markets, it increases the withdrawals, lowering the amount of money left in the portfolio that may be exposed to subsequent downturns. Hence, the sensitivity to the sequence of returns is lower, providing more certainty around the end value of the investment.
So while our GBBO contestants heed Mary Berry’s advice to carefully manage the ‘sequencing risk’ of their bakes to produce the perfect Yorkshires this week, income investors should be inspired to align distributions with the natural income of their portfolios.