When you are about to retire and you are going to rely on income from your investments and pensions that’s when you are most concerned about sequencing risk. Sequencing risk being the risk that the order and timing of your investment returns are unfavourable, resulting in less money for your retirement. This can occur for example if there is a large stock market crash shortly after you have started taking an income from your portfolio.
However, the reality is that if you are relying on the natural income from your investments and you are mostly invested in shares you have very little to worry about as long as your time horizon is at least 10 years. Why do I believe this?
Well, the reality is that the income from shares, the dividends, fluctuates very little annually especially in the UK and the US. Dividends tend to rise each year whereas share prices can be very volatile. In fact, apart from 2008 and 2020, dividends from UK shares have risen virtually every year for the last few decades. The dividend payouts are remarkably consistent much like the image below.
On the other hand, the valuation of shares has varied greatly over the same period of time. For example, we experienced large stock market falls on Black Monday in October 1987, in 2000-2002 (the end of the dotcom bubble), in 2008 (The Great Financial Crisis) and again in March 2020 (the start of the Coronavirus pandemic). Large stock market falls of typically 30% or more have occurred on these occasions. Dividends have pretty much continued to rise inexorably apart from two blips in 2008 and 2020 after which dividends resumed their annual growth. The following graph represents a fair reflection of what happens to share prices whenever there is a crash.
So the message is very clear that the level of income from dividends is far more consistent, reliable and less volatile than the share prices of the companies that actually pay them. So why does this matter?
Well, the reason why it matters so much is because once you are aware of this fact you really shouldn’t worry at all about what is going to happen to share prices in the short term. Why? Because if shares prices fall markedly it is still likely that dividends will continue to rise. Dividends can only rise annually if the company’s earnings (profits) rise every year too.
Guess what? In the long run share prices will rise relative to the increase in earnings. In the short term share prices may get out of sync but the general rule remains that share prices do reflect the earnings increases of the company annually. So in other words, even if share prices fall in the short term it is a) likely that dividends will continue to rise and b) share prices will recover as long as you are invested in companies whose earnings increase annually.
So what is the current dividend yield from the FTSE 100 Index? Well, it’s just under 3% currently but over the last 5 years, it has averaged about 4%. The reason for the temporary dip is because a number of companies reduced their dividends last year due to the Coronavirus and some of these reductions were enforced by the government on certain sectors e.g. banks.
FTSE 100 / 250 / All-Share – Dividend Yield & Annual Total Return
So knowing this you should be emboldened to invest your retirement funds into the market knowing there is a fairly high degree of probability that your natural income from dividends will continue to rise regardless of share price fluctuations in the short term.
The key is to ensure that you have a well managed, diversified portfolio in order to reduce investment risk and increase the likelihood of you achieving a rising income throughout your retirement.
So the message is not to worry about short term fluctuations in share prices. Timing the market doesn’t work anyway. Instead, invest your money and watch those dividends and your resultant retirement income grow.* You know it makes sense.
*The value of your investment can fall as well as rise and is not guaranteed. Past performance is not a reliable indicator of future results. The contents of this blog are for information purposes only and do not constitute individual advice. You should always seek professional advice from a specialist. All information contained in this article is based on our current understanding of taxation, legislation and regulations in the current tax year. Any levels and bases of and reliefs from taxation are subject to change. Tax treatment is based on individual circumstances and may be subject to change in the future.