Sequence of returns risk is the risk that your portfolio will have lower returns in the early years of your retirement. One of the worst things that can happen to a pre-retiree is for the market to drop the year in which they retiree. This happened to almost everyone in 2008. Those that retired and thought they had a million dollar portfolio to live off of soon saw their portfolios’ get cut in half. They were faced with cutting back their retirement lifestyle, no longer as wealthy as they were last year.
Take a look at the chart below for an example of two different retirees’ portfolios. Both start out with a $1 million portfolio and both take $50,000 from their portfolios each year. Both investors have the same average return over the ten-year period of 6.27% (not using compounded annual growth rate here). However, after 10 years Investor A has much more than Investor B. What happened? Sequence of returns risk happened. Take a look at the return column. One investor had higher returns in the beginning of the ten-year period. Because the higher percentage return occurred when the value of Investor A’s portfolio was high, he made more money on his money.
Actuals vs. Hypotheticals
Return sequencing matters in the real world. And that’s the world you and I live in. It’s nice to get some fancy charts from a financial advisor that shows how your money will grow over time or how much income will be generated each year. But none of that really matters. Instead it’s how your actual portfolio is performing and the actual money that’s coming into your checking account from your portfolio that matters.
I majored in finance in college, naturally. The entire study of finance is based on hypothetical forecasts that may or may not happen. It’s based on assumptions that also may or may not happen. I was amazed by all of this at first. You mean someone is going to hire a college kid to forecast what may or may not happen in the future based on assumptions that are likely off the mark? Wow! What a country!
The real world is entirely different in practice. When you’re trying to manage your portfolio to generate income and perform well during the long term, sequence of returns risk really matters. I can’t think of a greater underestimated risk than sequence risk; it’s something to keep in the forefront of mind when investing.
Reducing Sequence-of-Returns Risk
1) Stop Withdrawal During Down Years – You could not withdraw capital from your portfolio during down years. This would certainly help keep the value of your portfolio intact so it could have the fighting chance to come back during the up years. This may or may not be good advice depending on if you actually need the money. Some retirees have other options that they can tap into like savings, equity, etc. The plan here would be to not withdraw from your portfolio if you had a down year and instead take money from your savings. Then you could replenish your savings during an up year, thus giving you more money in the end (I ran the numbers and this actually does make sense).
2) Reduce Exposure to Begin With – Folks that read my site regularly know that I recommend investing in three (3) different asset categories: risk-free, core, and alternative. The entire premise behind the modern portfolio theory is that certain assets will go up while others go down. Also, you can actually have a higher return with less risk. I know it sounds counterintuitive because most people think that more risk equals more reward but this isn’t always the case.
Interest rate sensitive securities like bonds and REITs will perform differently than growth stocks, for example. Your return will be impacted by the types of securities in which you invest. Plan and simple. By working to get a good mix of assets in your portfolio, you’re less likely to have big down years. This is especially important in the distribution phase of your portfolio.
3) Withdraw a Percentage of Remaining Portfolio – Most retirees withdraw from their portfolio at a constant rate. The 4% rule is an example of this. Withdraw 4% the first year you need income and then index that percentage to inflation so that your standard of living doesn’t decrease. A different approach could be to withdraw 4% of your remaining portfolio. Example would be to withdraw $40,000 from a $1,000,000 portfolio in year one. Then the market drops in year 2 and you have also withdrawn money so that your portfolio balance is $900,000. With this method, you would withdraw $36,000 from your portfolio in year 2 (4% constant rate x portfolio balance of $900K). This method is not ideal and but would be okay if you had spending flexibility in retirement.