Market timing and retirement what matters most

Timing the market is often the siren song of investing. It sounds like a perfect way to maximize gains or avoid losses, but for those already in retirement, it can quickly become a high-stakes gamble with little to no room for error. 

Countless studies demonstrate that the majority of ‘active’ traders will underperform their more passive counterparts, giving credence to the old adage “time in the market beats timing the market”.

The mirage of the perfect entry

For a retiree, the psychological pressure to “do something” during a downturn can be immense. After all, these are your retirement savings on the line. Timing the market, however, is notoriously difficult because it requires you to be right twice once on the way in and again on the way back out. 

Data collected to measure investor behaviours consistently shows that investors who actively attempt to time the markets, lose-out on average. This occurs in part because the market’s best performing days often occur within days of its worst. Zoom out wider and you tend to find this trend occurs on a year by year basis too, not just day by day. 

Therefore, when you exit the market to avoid a slide and miss just a handful of those recovery days, weeks or years, the impact on your long-term internal rate of return can be detrimental. In retirement, you may no longer have the salary to bridge the gap if your timing is off. You are essentially betting your future purchasing power on the hope that you can outsmart millions of other investors, and increasingly, high-speed algorithms.

The rising stakes of age

While a 30-year-old can treat a market mistiming on their retirement provisions as a learning experience, a retiree faces much more unforgiving set of odds. As you age, your investment horizon shortens, meaning you have less time to recover from a significant mistake. 

Moreover, any asset which generates a return is capable of compounding over time, but it can take a long time to become visible. If you’ve ever seen a graph plotting a form of exponential growth, you’ll know that the line spends quite a while steadily rising, before beginning to steepen increasingly sharply. This is to say that the returns you might see in a single year, 30 years from your initial investment would likely dwarf the returns (nominally) that you saw in the first few years. 

Compounding growth is essential to achieving a strong rate of return on your money, and this is precisely why there are rules on when you can access your pension, for instance, as the government wants to ensure you capture as much of it as possible. Ideally, you want to continue to capture that compounding returns for as long as possible.

As discussed, the desire to ‘do something’ when markets see a downturn can be immense, particularly as you near retirement, but it’s important that we consider the bigger picture. If you move your investments to cash at the bottom of a cycle and wait too long to reinvest, you risk locking in your losses, and also missing out on some of the returns available in a recovery. This can effectively shrink your nest egg permanently. After all, global markets have historically spent more time going up than they have going down; so too therefore has your average investor who simply remained invested throughout those ups and downs.

When timing matters sequencing risk

Despite the dangers of active market timing, there is a specialized version of timing that retirees really should consider sequencing risk. It refers to the phenomenon of lowering your long-term returns by poorly timing a withdrawal of assets during a market downturn. This isn’t about guessing where the S&P 500 will be next Tuesday; it’s about the timing of your withdrawals relative to the performance of your investments. 

Let’s say you start retirement and the markets take a tumble, and the portfolio falls 20%, and you also withdraw 20% of the portfolio’s original value whilst it’s down, effectively liquidating shares at what is now a large discount. Ex-post, your portfolio is now 40% smaller than it was originally. When the markets do eventually recover, 40% less capital is now seeing that recovery. In mathematical terms, you would now need a return of 66% to return to your starting value (at retirement). Had you avoided withdrawing 20% during the downturn, you’d only need a return of 25% to return back to your starting point. That’s a big difference.

As you see, sequencing losses can have a serious, double-whammy style effect on your investments values, not just because you’re crystallising and withdrawing your shares at a lower valuation, but also because the value of remaining funds – which you expect to see recover – is now smaller, harming your ability to compound returns and indeed requiring more % returns to get back to your starting values.

With that in mind, as investors perhaps we should be “timing” the market defensively, not by jumping in and out, but by using buffer assets like cash or lower risk investment portfolios to avoid selling our more volatile assets during times of volatility.

So what can you do?

The cash buffer strategy this is the practical solution to the problems we’ve identified. Keeping anywhere from 1-3 years of regular spending in cash and savings products allows a retiree to almost ignore market timing and sequencing risk because they aren’t forced to sell when the market is down. On the contrary, you might decide to gradually draw upon your investment portfolios to replenish the cash-buffer over time, ideally when markets are doing well. In doing so, you are gradually de-risking the sum of money invested so that you can draw upon your risk free and low risk assets, whilst allowing your higher risk assets to continue to grow.

The impact of inflation many retirees “time” the market by moving everything to safer assets or cash when they get scared. Whilst feeling like this reduces risk, it introduces a rather different kind of risk purchasing power risk. If you stay out of the market too long, the value of your funds might survive a market-crash, but are then faced with the more probable risk of losing money to inflation. As we’ve identified above, having a cash buffer is an essential part of planning your finances – but it’s all about finding a balance.

Spread your risk bearing the above in mind, one of the most rational things we can do as investors is to spread our risk, based on when we’ll need our funds. The ‘cash buffer’ is essential to allow us to continue our day to day spending without requiring any immediate action and reaction on our investments. The key here is ultimately to minimize sequencing risk, and ensure we’ve got liquidity to cover our essential and daily needs.

It might also then be wise to have some well-balanced, diversified investments with a medium-term time horizon, say between 3-6 years. Ideally, this more balanced blend of assets can still deliver us strong risk-adjusted returns on average, but not be massively volatile in the event that we need to dip into them, and or use them to replenish our cash bucket. As time goes on, we might slowly and regularly divest from this pot to replenish our cash position. Making regular (as opposed to larger, ad-hoc) withdrawals from an investment is another good way to mitigate the risks of timing the markets.

Assuming we continue to keep these two pots managed and maintained as necessary, we can still afford to take on a fair amount of risk on our longer term savings, those which you may not reasonably need to access in 7 to 10 or more years. 

We know that on average, the higher risk of your investment portfolio, the greater your capacity for expected returns. We also know that not all of our savings and investments will be used for the same purpose. It’s therefore essential that we don’t keep all our eggs in one basket, so to speak. Having a balance of pots with differing risk/return profiles, and with different time horizons is a great way to manage your overall exposure to market volatility, and to be able to draw upon your investments whilst minimising the risks that can come with timing the markets.

Ultimately, while the strategies discussed here provide a framework for defending your wealth, there is no one-size-fits-all blueprint for a perfect retirement. Your unique goals, family considerations, and desired lifestyle will inevitably shape the way these principles are applied to your portfolio. We invite you to get in touch with us for a more personal discussion; we can move beyond the theory to discuss your specific circumstances, offering the guidance and technical expertise necessary for you to feel comfortable in retirement.

Please remember that when investing, your capital is at risk. The value of your portfolio with Moneyfarm can go down as well as up and you may get back less than you invest. Past performance is not a reliable indicator of future performance. The views expressed here should not be taken as a recommendation, advice or forecast. If you are unsure investing is the right choice for you, please seek financial advice.