Sequence Of Returns

Stewart Ogilby

One must not ignore these two "elephants in the room"

Elephant Elephant
Risk Elephant #1 Risk Elephant #2

ELEPHANT #2: THE SEQUENCE OF RETURNS RISK

This is one of the most important financial planning principles that you will ever find. Understanding it may determine whether or not your family runs out of money years sooner than expected.

To find the average of the following numbers:

+8.3 +29.1 +31.2 -5.7 +5.6 -38.8 +6.4 +14.1 -4.0 + 22.5

  • Add up all the numbers = +68.7
  • Divide +68.7 by the number of items (10)
  • No matter how the order, or sequence, of the above numbers is changed, their average is always 6.9 (rounded to the nearest 0.1).

Suppose that the above numbers represent annual percentage returns within a savings or investments portfolio during a 10-year period. The order in which those returns occur is known as "the sequence of returns". Although the average remains the same regardless how you jumble the numbers, it is the order, or sequence, in which these returns occur that largely determines how long your retirement money is going to last you and your family.

The values of separate portfolios all starting at the same size and all averaging exactly the same average return throughout a span of years, can vary substantially depending upon precisely when one happens to retire.

To repeat: When approaching retirement, or in retirement and drawing income, it is the sequence of returns that largely determines how long your money is going to last you and your family. One may wonder why this financially terrifying risk may not be fully explained by employees of multi-billion dollar banks and financial service corporations.

When income begins to be taken from an accumulated portfolio, an understanding of the sequence of returns principle is even more critical. Retirees who are taking an income stream from their portfolio and who experience negative returns early in retirement, regardless of average annual yields, run out of money years sooner.

The measurement of repeated ups and downs of financial markets is known as "volatility". Sometimes it takes years for a portfolio to regain losses experienced during drop-downs, the most recent cyclical one (as of this writing) being in 2008. This fact, in combination with the sequence of returns principle, demands that older investors move into low-risk and low-volatility investments.

Below is a graph illustrating the impact of the sequence of returns. It assumes a $100,000 portfolio with an annual withdrawal of $9,000 for a 65-year-old. There are three scenarios. The average return in all three portfolios is 7% but the sequence of annual returns varies. This was prepared some years ago. The size of the portfolio and annual withdrawals can be multiplied proportionately to better reflect current numbers and the principle remains the same:

  • In Scenario #1, with a constant 7% annual return. Income stops at age 86
  • In Scenario #2, the portfolio experiences a single poor return early (-13%, followed by +7% and +27%). Income stops at age 81
  • In Scenario #3, positive returns are achieved at the beginning, before a negative year (+27%, followed by +7% and -13%). Income lasts to age 95.

Sequence of Returns Graph

Astute investors are aware of corporate interests and of the commissions interest of salespersons. In addition, they are aware of market volatility, cycles of exuberant growth in their investments followed by market “corrections” every 5-7 years, on average. Advised to “buy and hold”, they think that because market values eventually exceeded previous gains and because they saw markets crash but recover repeatedly, they make the dangerous mistake of viewing volatility as simply a minor inconvenience.

As one's portfolio grows over a number of years, losses may be offset by gains. When investors enter their retirement zone, the sequence of returns issue becomes critical because time is no longer on their side.

As markets and individual stock prices go up and down, salesmen generally continue to "work with" retired clients to generate their commissions. Volatile returns experienced as one nears and enters retirement can have huge impacts on one's accumulated wealth although the resulting damage is often not immediately recognized. The probability of having even just one severely negative year early in retirement is totally unacceptable. Its results can be personally devastating.

  • Question: If the average return in my portfolio is 8%, why can't I withdraw 8% a year from my retirement portfolio and never run out of money?
  • Answer: Because the sequence of returns is unpredictable. If you remain invested in the stock market, for example, and experience a couple of bad market years at the beginning of your income-withdrawal phase you may run out of money because, in all likelihood, there is not enough time to recover.

The most important fact for seniors to understand: Sequence of Returns is their number one investment enemy. A strategy is needed to avoid losses in one's portfolio, regardless of subsequent gains.

Commissioned salespersons of huge financial service organizations, banks and broker-dealers, when faced with losing informed clients who grasp the sequence of returns issue, propose solutions such as cash set-asides, laddering of bonds having different maturities, and the widely practiced “solution” of shifting from stocks to bonds. An online search reveals a number of other ways proposed to cope with this huge risk. Some of these, including a complicated options strategy (costless collars) can be confusing and burdensome, particularly for older heads. Various strategies are touted, unsurprisingly, with a view to keeping clients and preserving corporate incomes.

In order to prevent potential unrecoverable losses, investors who are approaching retirement or in retirement need a non-commissioned fiduciary advisor who employes a strategy that has in the past proved to be effective in minimizing portfolio volatility and decreasing risk while producing competitive returns.

Combined with the necessity of minimizing risk posed by the Sequence of Returns Principle, it has been pointed out that low volatility investing works, per se, long term. A widespread understanding of this would probably decimate incomes of many commissioned salesmen.

If you have questions after dealing with banks, corporate wire-houses, stockbrokers, and insurance company salesmen feel free to contact me.

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