Financial advisers and fund managers are making assumptions about investors’ attitudes to risk based on insubstantial evidence, according to a new white paper from Chancery Lane Research.
The Retire well paper delves into a number of areas, including volatility as it relates to dividend income, the limitations of modern portfolio theory, and the merit of a natural income approach to retirement planning.
In forming its views, the authors carried out a comparative analysis of alternative income drawdown strategies between 1986 and 2023, comparing low-cost index tracking, 60/40 equity/bond portfolios, and natural income strategies.
The paper said using volatility as the main measure of risk can be misguided, as while it is a valid measure, the risk is not one of the fluctuation, it is a risk of an adverse behaviour.
See also: Nine in 10 advisers say capital gains tax becoming greater concern
Chancery Lane said the two biggest risks for an individual depending on drawdown income are sequence and longevity risks, which can be removed by investing for natural income via assets with a cash buffer such as investment trusts.
“Seeing the value of their savings fluctuate will make any investor anxious, but even the risk-averse may prefer some turbulence to the possibility that they may not have enough money to live on in retirement,” the paper states. “Believing that a downward fluctuation in diversified savings will create to a loss is irrational, albeit an enormously strong emotional belief.”
According to the research house, evidence suggests that equity volatility is “a risk well worth considering”, particularly if the asset class is represented by a well-chosen portfolio of investment trusts.
See also: ‘Generational divide’ between seasoned advisers and newcomers
Investors may face less volatility of income with such a portfolio than they would with a classical modern portfolio theory-based one of 60% equity and 40% bonds.
Sequence risk is the most destructive risk when an investor is drawing income, and that risk is removed by using natural income, according to the researchers.
“We think the simplicity of the natural income approach is more predictable, more valuable and – ultimately – more reassuring for investors, particularly those retired,” the researchers said.
“It meets what is required by most pension drawdown investors: an income for life, rising each year to counter inflation, with a good degree of certainty. The outcomes meet investor expectations.”
See also: David Jane: Turning volatility from retirees’ enemy to friend
