Which would you choose as investment performance, assuming a £10,000 investment that would be untouched for 10 years?
- A steady return of 5% a year throughout the period; or
- Two years of 20% annual losses followed by eight years of 12.39% a year growth.
The outcome in both instances would be the same: both would produce an overall gain of £6,289. Compound interest can produce many surprises if you are not accustomed to its effects.
Now, try something a little more difficult. Use the same two sets of investment return, but now assume you withdraw 5% of your original investment (£500) at the end of each year. Which would you choose?
- A 5% return on £10,000 is £500, meaning the growth will be removed at the end of each year, so after ten years there will be £10,000 remaining.
- With a varying growth pattern, you need a spreadsheet to give a quick answer (or a calculator and paper for the slower version). Either way, at the end of ten years, £7,761 is left.
The £2,239 difference is an illustration of an effect known as ‘sequencing risk’. At first sight the gap between the two results appears too large – after all there is no difference when there have been no withdrawals.
However, drill down and what is happening becomes apparent. At the end of two years, taking £500 a year out from a fund that has been falling by 20% a year, leaves you with just £5,500. Suddenly a withdrawal that was 5% of your original investment has become 9.1% of the remaining capital. Even a growth of 12.39% a year thereafter cannot rescue the situation.
These calculations make a point which you should consider if you are taking regular withdrawals from your pension or are planning to do so soon. The recent declines in investment values make it important that you review your level of withdrawals and consider other income options. This is an area that needs expert advice: the wrong decision can leave you with an empty pension pot, but still plenty of life left to live.
The value of your investment, and the income from it, can go down as well as up and you may not get back the full amount you invested.
Past performance is not a reliable indicator of future performance.
Investing in shares should be regarded as a long-term investment and should fit in with your overall attitude to risk and financial circumstances.