Paul's Insights: Wrong place, wrong time
One mistake the team at InvestSMART often see, is people holding investments that don't match personal goals.
A classic example of this mismatch is someone planning to buy a first home in a year or two investing their savings in shares. Murphy’s law says a pull-back in equities will occur right when you plan to cash in your stocks. That can potentially set you back from achieving your goal for another year, maybe more.
This wrong place/wrong time scenario has a name – ‘sequencing risk’. It refers to the chance that your investments could take a dip just when you’re relying on them to achieve a certain goal.
The reality of sequencing risk hit home during the global financial crisis. Equity markets took a bath in the red, and pre-retirees who had invested heavily in shares (which, to that point had skyrocketed ahead), could do little but watch as the value of their retirement savings nose-dived. For many, the only option was to delay retirement until equity markets – and their super savings – had recovered their value.
There are ways to avoid sequencing risk. The key rule of thumb is to match investments with the timing of your plans.
Short term goals like saving for a first home in the next few years, call for short term investments such as fixed rate deposits and high interest savings accounts. Yes, returns on cash are at record lows. But if you plan to get into a place of your own sooner rather than later, it makes sense to play it safe with a less volatile investment than shares.
If, on the other hand, you’re aged in your 40s or 50s and saving for retirement, investing your super in a high growth strategy that’s focused on shares can make sense. Markets may take a bath in the red before you’re ready to hang up your work boots. But over a period of 10 or 20 years, shares will typically go on to recover from market lows, and potentially reach new highs.
For all investors, sequencing risk also highlights the need to diversify.
Keeping a cash reserve is especially important as you head into – and continue through – retirement. If the worst happens and your investments are hit by a market downturn, at least you can live off cash savings without the need to sell other investments, potentially at a loss, to maintain your income.
Keeping a chunk of your wealth in cash comes with an opportunity cost, particularly in these low rate times. So deciding what sort of cash reserve you need can be a juggling act. However, the peace of mind that cash holdings can provide may compensate for the loss of potential returns on other investments, especially if it takes you a step closer to your goals.
To see if your risk profile is in line with your goal, check out InvestSMART's investment goal calculators.
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Paul Clitheroe is Chairman of InvestSMART, Chairman of the Australian Government Financial Literacy Board and chief commentator for Money Magazine.