Sequence of Returns Risk
We have a pretty solid and steady bedtime routine. First, it’s bath. Next, it’s pajamas. Then it’s teeth. Last, it’s books. Or as we like to call it, bath, books, bed. The kids know the routine and follow it closely. If we happen to go out of order it creates a problem. To keep everyone, parents included, happy, we follow our routine.
When we talk about investment management, we try to get everyone to focus on the long-term. The system is fairly straightforward, too. First, pay yourself at the start of each month. Next, invest into a globally diversified portfolio. Then be patient. Last, repeat until retired.
This whole investing monthly system is known as dollar cost averaging. It should work out in the long-term, and the day-to-day fluctuations of the portfolio don’t really matter. Unfortunately, what many investors tend to focus on are the bumps in the road, more so than the destination.
For the buy and hold investor, sequence of returns doesn't really matter
If you’re young and accumulating funds, don’t worry if now is a good time to invest. While getting the timing wrong and having your portfolio drop right away hurts, it should not really matter in meeting your long-term goals. You’ll end up in the same place.
With no cash coming out, how your returns perform in a given year doesn’t matter. What matters is the average compounded rate of return over time. In our example above, that’s 3.42%. Starting with $1,000,000 you end up with $1,183,400 regardless if you get off to a great start or a bad start.
Sequence of returns is having a good start or a bad start for your portfolio, over a given period of time. And it can matter tremendously when cash is going out of an account, especially when it coincides with a bad start.
Sequence of returns makes a big difference for a portfolio in withdrawal
Unlike a buy and hold investor, someone withdrawing funds from a portfolio cares deeply about the sequence of returns. Whether or not you start with a good sequence or a bad sequence is highly relevant. A bad starting sequence may mean exhausting funds quickly, whereas a good starting sequence may mean being able to spend more for longer.
This is an important concept for everyone’s retirement plan and is known as sequence of returns risk. The risk is most salient in the first five years of retirement.
Using the same good start, bad start from above, a retiree withdrawing $50,000 per year ends up in two different places.
The portfolio that started withdrawals during bad market years is $100,000 lower after 5 years. Though each portfolio experienced the same compounded rate of return, the bad start portfolio just lost 2 years of spending power.
Fortunately, there are some simple ways to protect against sequence of returns risk.
Protecting against sequence of returns risk
When entering retirement, there are a whole list of variables we need to solve for. Two critical ones are how much we need to spend from our portfolios and how long we need our portfolio to last. For almost everyone, stretching a portfolio over 20, 30, or even 40 years in retirement requires ongoing stock market investing to protect purchasing power.
Yet, with stock market investing comes volatility, and it’s this volatility that can give us a bad sequence of returns to start our retirements!
The "bucket" approach
One way to protect against a bad starting sequence is to hold a certain amount of cash so you don’t have to withdraw from stocks in bad years. Let’s call this the bucket approach. You fill your bucket with three to five years of spending needs, refilling it with cash as needed by rebalancing during normal and good years, and during bad years, leaving your stock investments be. If a bad start takes years, you may be left holding a portfolio of mostly stocks. Hopefully, the market rebounds before the bucket runs out. It usually does.
The "hedge" approach
Another way to protect against a bad starting sequence is to realign your portfolio to hedge your bets. That means if you determine you need a 60% stock and 40% bond portfolio to see you successfully through retirement, then temporarily de-risk the portfolio in the years before retirement. So, in the three to five years before you need to start withdrawals, move the portfolio to a 40% stock and 60% bond mix. By holding more bonds immediately before retirement, you hedge your bets. This added conservatism takes some stock market risk out of the portfolio and makes you less susceptible to a bad start. After three to five years in retirement, you can move the portfolio back to 60% stocks and 40% bonds.
Accumulation vs. decumulation
Accumulating funds for retirement requires a long time horizon and patience. You will most likely experience several bad markets with poor investment results along the way. But as long as you keep on investing, the actual sequence of returns doesn’t really matter. What matters is your average rate of return over the entire period you are accumulating wealth for retirement. The higher the average, the more wealth you’ll have to live on.
Decumulating funds in retirement also requires structure and patience. You want to protect against bad markets and poor investment results early in the withdrawal cycle. You especially want to protect again a bad start right at the beginning. It’s possible that with a bad start, even if it’s followed up with positive returns, you can still run out of money. Sequence of return risk is a real concern for new retirees and can make a big difference in your financial health in retirement.
The best defense is to manage your retirement portfolio accordingly. Know where you are in your long-term plan and be sure to have an asset allocation to match. If you’re far from retirement, stop worrying if now is a good time to invest. Just do it. If you’re getting close to retirement, have a protection strategy in place to manage your exposure to sequence of returns risk.
If you'd like to discuss what you can do to protect against sequence of returns risk, use the button below to schedule a free consultation.
Adam K. Wright, CFA, CFP®
Adam guides the vision and implementation of our fiduciary service approach and directs the firm's client engagement, service integration and investment management practices.
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