3 min read
Consider the following thought experiment:
Scenario 1: Bob starts with a portfolio of $100. In year one, his portfolio earns a 10% return. In year two, it earns a -5% return.
Scenario 2: Bob starts with a portfolio of $100. In year one, his portfolio earns a -5% return. In year two, it earns a 10% return.
Question: Which scenario ends with a higher ending value?
Answer: Both result in the same ending value.
The sequence of returns – the order in which the returns occurred – didn’t matter.
Since Bob doesn’t withdraw any money from his portfolio in either scenario, the sequence of his investment returns doesn’t affect the ending portfolio value.
But let’s see what happens when Bob decides to withdraw $10 from his portfolio at the beginning of each year:
Explanation: In scenario 1, Bob withdraws $10, which takes his portfolio down to $90. He earns a 10% return in year 1, which takes it up to $99. Then he withdraws another $10, which takes his portfolio down to $89. He earns a -5% return in year 2, which takes it down to $84.55.
In this example, the sequence of returns does matter. In scenario 2, the bad return in the first year caused the portfolio to have a lower ending value compared to scenario 1. This illustrates the first important rule of sequence of returns:
Bad returns in early years cause more damage to portfolios than bad returns in later years.
This is the basis for the term “Sequence of Return Risk”, which is the risk that all retirees face. When you retire, you rely on your portfolio to earn investment returns to offset the money you’re withdrawing to support your lifestyle.
Based on research, it has been shown that bad returns in the first year or two of retirement don’t actually matter much in the long run as long as your portfolio recovers its lost value within the first decade.
The real threat comes from earning poor returns overall during the first decade of retirement.
These poor returns in the early years could wipe out enough of your portfolio that even good returns in later years wouldn’t be enough to keep your portfolio alive.
Let’s use some real-world numbers to illustrate this concept.
The numbers used in this example are grossly oversimplified, but they’re useful in illustrating the sequence of return risk.
Suppose Bob retires with a portfolio worth $1 million. His retirement lasts 30 years. At the beginning of each year, he withdraws $40,000 from his portfolio to support his lifestyle.
Bob experiences three decades of market returns.
In one “bad” decade, he earns -1% annual returns.
In one “mediocre” decade, he earns 4% annual returns.
And in one “good” decade, he earns 8% annual returns.
The sequence in which he experience these returns matters.
Consider scenario 1, where he experiences the “bad” decade first, followed by the “mediocre” decade, then the “good” decade.
In scenario 2, he experiences the “mediocre” decade first, followed by the “bad”, then the “good” decade.
Assuming Bob withdraws $40,000 from his portfolio at the beginning of each year, here is how his portfolio performs in each scenario over 30 years:
Here’s a visual look at both scenarios:
In scenario 1, the bad returns in the first decade depleted his portfolio so much that the better returns in the following two decades weren’t enough to keep his portfolio afloat.
Conversely, in scenario 2, the mediocre returns in the first decade were enough to keep his portfolio alive until the good returns showed up in later years.
Dealing with Risk
If history is any indicator of future stock market performance, we know that there will be a mix of bad, mediocre, and good decades in the years ahead for investors. If your first decade in retirement is a “bad” one, with poor returns, your portfolio is at risk of drying up during a multi-decade retirement.
On the other hand, research shows that if your portfolio maintains or increases in size during your first decade of retirement, the odds of your portfolio surviving over the long haul are fairly high.
So, to prevent your portfolio from getting crushed in the early years of retirement, there are a few steps you can take:
1. Invest in bonds. If the market flops in your first decade of retirement, it’s helpful to own bonds, which will maintain their value far better than stocks. In the event of a flop, you can sell off some bonds.
2. Hold cash. As we saw in the very first example of this post, if you don’t touch your investments, your portfolio can endure a downturn if the market recovers in later years.
To avoid selling your stocks, it helps to have cash on hand. Many early retirees hold as much as 1 – 3 years of cash in a savings account to ensure they don’t have to sell their stocks to support their lifestyle in the early years of retirement.
3. Keep spending in check. The most obvious way to give your portfolio a boost is to simply kick up your frugality and spend less during market downturns. This will help you stretch your cash reserves and avoid selling stocks.
What are your thoughts on sequence of return risk? Do you have any other tips to deal with this risk?
Zach is the author behind Four Pillar Freedom, a blog that teaches you how to build wealth and gain freedom in life.
Zach's favorite free financial tool he's been using since 2015 to manage his net worth is Personal Capital. Each month he uses their free Investment Checkup tool and Retirement Planner to track his investments and ensure that he's on the fast track to financial freedom.
Although the bulk of his net worth is invested in index funds, his favorite place to invest in individual stocks is M1 Finance, a site that allows you to build a custom portfolio of stocks for free.
His favorite way to save money each month on his recurring bills is by using Trim, a free financial app that negotiates lower cable, internet, and phone bills with any provider on your behalf.
His favorite place to find new personal finance articles to read is Collecting Wisdom, a site that collects the best personal finance articles floating around the web on a daily basis.
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