Why Sequencing Resilience Is Built Before The Fall

The week the fear gauge reminded us

Last week offered a small but useful lesson in how quickly sentiment can turn. The Cboe Volatility Index, the VIX, closed at 21.15 on 2 November, climbed to 28.18 by 5 November, and was reported as heading for its highest close in five months. It eased to 25.64 on 6 November and then fell sharply on Monday, closing near 20. Its 52-week range runs from roughly 13 to 35.

None of this signals a crisis, and it would be a mistake to read it as one. The VIX is a measure of what protection costs, not a forecast. Yet a week like this is exactly when a retiree who is drawing an income feels something different from an accumulator, and it is that difference that this article is about.

Why the same volatility feels different

During accumulation, salary, contributions and time give investors natural recovery capacity. Falling markets even offer the chance to buy at lower prices. In retirement, contributions stop, withdrawals begin and the time available to rebuild capital becomes finite. Natural recovery capacity declines while loss-aversion sensitivity rises.

This is the heart of sequence of returns risk, a concept established by William Bengen in 1994 and reinforced by the Trinity Study, Wade Pfau, Michael Kitces and others. Consider two retirees who each begin with 1 million dollars, withdraw 60,000 dollars a year and earn the same 6 per cent average return over ten years. The only difference is the order of returns. One finishes with about 539,000 dollars and the other with about 899,000 dollars, a gap of roughly 360,000 dollars created by sequence alone.

Recovery is a journey, not a date

Markets are said to have recovered when an index regains its previous peak. For a retiree, recovery is the entire path from peak to trough and back, with withdrawals continuing throughout. Analysis of US share market falls greater than 20 per cent between 1956 and 2022 shows how uneven that path can be. The 2020 decline completed its full peak-to-recovery journey in about 181 days. The decline that began in 1973 took 2,744 days, and the one that began in 2000 took 2,623 days.

The 1973 to 1980 episode is instructive. The market fell 48.2 per cent, then took 2,114 days from its low to regain the old high, with roughly ten meaningful upward resets and eight meaningful downward resets along the way. The market records the eventual recovery. The retiree experiences the path of returns.

At the start of any decline, neither adviser nor client knows which of these histories lies ahead. That uncertainty is the portfolio construction problem.

What cash can and cannot do

Advisers commonly hold one to three years of planned withdrawals in cash or liquid defensive assets, and rightly so. Cash funds spending and reduces the pressure to sell growth assets at depressed prices. But cash can provide time. It cannot determine how much time markets will require, and it cannot by itself preserve a client's confidence while the remainder of the portfolio falls by 25 or 30 per cent.

Liquidity and confidence are different retirement objectives. A resilient strategy addresses both, and this is where Behavioural Survivability becomes practical rather than theoretical. It is established before a decline occurs, not during one.

The case for a protective allocation

The Retirement Portfolio Resilience framework proposes that a retirement portfolio should intentionally perform four functions: Growth, Defensive, Retirement Income and Retirement Portfolio Resilience. The first two are familiar asset allocation decisions. The last two are portfolio functions, and the resilience function exists specifically to address sequencing risk and behavioural survivability.

Dynamic hedging is one established institutional discipline that can contribute to that function. Using derivatives and option overlays, managers adjust portfolio characteristics as conditions change, with the aim of influencing how a portfolio behaves rather than predicting markets. Russell Investments, AQR and BlackRock all apply versions of dynamic risk management, and the academic literature on portfolio insurance and option overlays stretches back decades. Relevant characteristics include embedded downside protection, lower correlation with traditional assets and, in some designs, exposure that strengthens as volatility rises.

That last point connects directly to the week just passed. A spike in the VIX is uncomfortable for a portfolio built only from growth and defensive assets. For an allocation designed to respond to rising volatility, it is the environment the design anticipates. Allocating a part of the portfolio to such a protective fund can therefore help clients benefit in two ways. It may cushion capital in a drawdown, and it may make it easier for the client to stay the course.

Judging the evidence

Advisers should assess any resilience allocation as they would any other portfolio function, by observing its behaviour. Three questions help. How has it behaved in significant market declines? How has it participated across falling, volatile, stable and rising markets? Has that behaviour stayed consistent through time?

Australian data offers one illustration. Over the five worst quarters of the ASX Accumulation Index since one dynamic hedging fund's inception, the index fell by between 6.58 and 23.10 per cent, while the fund delivered positive returns in four of the five quarters and a small loss of 0.26 per cent in the other. In the first quarter of 2020, the index fell 23.10 per cent and the fund returned 9.22 per cent. Past performance does not guarantee future outcomes, but it is the right kind of evidence to ask for.

The stewardship implication

Volatility will come and go. The VIX will fall back toward its lows and rise again, and no one can say in advance which episode will become the long one. The stewardship question for advisers is whether a client's portfolio was built for the path rather than only the destination.

For the industry, the implication is a shift in vocabulary. Sequencing resilience is not a product pitch. It is a category of portfolio function that deserves the same deliberate treatment as growth, defence and income. The advisers who place it on the retirement checklist before the next decline arrives will be the ones whose clients remain financially and emotionally invested when it does.