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Finance Series: investment-and-risk

How trend following investment strategies can reduce the risk of poor returns during retirement

Sequence risk poses a threat to the investment returns of those dependent on a defined contribution pension scheme during their twilight years. This paper demonstrates how sequence risk can be significantly reduced by applying trend-following investment strategies.

Author(s): Professor Andrew Clare - Cass Business School; Professor Stephen Thomas - Cass Business School; Peter N. Smith - Chair in Economics and Finance, University of York; James Seaton - Cass Business School

With the decline of defined benefit (DB) pension schemes around the world and an increased onus on individuals to make their own investment and withdrawal decisions, decumulation strategies are being devised that are ever more inventive. However, there has been a seeming reluctance from economists in forming decumulation strategies involving risky assets, preferring instead to focus on risk-free benchmarks of index-linked bonds. This paper argues that this constitutes a flawed, incomplete approach and determines to shift the focus back to investment strategy.

Put simply, decumulation is the process of drawing money out of a pension pot, or drawing down savings, to fund retirement. When regular withdrawals from investments are made, there is an increased chance that the timing of these withdrawals could lead to a poor return. This is otherwise known as Sequence Risk and is a particular concern for those whose retirement is to be financed by a defined contributions pension scheme.

Using US equity return data from 1872-2014 this paper investigates the decumulation experience of a US investor with a 20-year investment horizon. The research finds evidence to suggest that the application of a simple trend following filter to an equity investment can help generate returns with low drawdowns. Trend-following is where one invests in an asset that is in an uptrend (defined as a current value above some measure of recent past average) and switch into cash when the current value is below such an average. This paper shows that a simple trend-following strategy can significantly reduce sequence risk while generating solid average returns.

The paper also addresses the question of whether indicators of equity market valuation are useful for predicting the withdrawal rates at any point in time. It finds evidence that the cyclically adjusted price-to-earnings ratio (or CAPE) can be used to enhance withdrawal rates.

The paper has been published in Financial Analysts Journal.

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