Sequence of returns risk, what is it and how to manage it?

Sequence of returns risk can certainly be a retirees worst nightmare. Completely out of your control, and at the whims of the market.

 

To recap: sequence of returns risk is a portfolio risk that is based on the order of your returns, rather than your average return when in the decumulation phase of your investment strategy. You see, if you aren’t withdrawing, the order of your returns makes no difference, but if you are withdrawing the order of your returns makes a massive difference.

 

Let’s look at 4 simple examples. Each portfolio with $100,000 and averages 4.75% over the three yer period. The first will have no withdrawals and have bad returns first, the second will have no withdrawals and have good returns first. The third will have bad returns first with $10,000 per year withdrawn at the end of each year. The fourth will have good returns first with $10,000 per year withdrawn at the end of each year.

 No Withdrawals, Bad Returns First:

 

Table showing returns over the years

 

No Withdrawals, Good Returns First:

 

 

 

 

Withdrawals, Bad Returns First:

 

 

 

 

Withdrawals, Good Returns First:

 

 

 

As you can clearly see, the order of your returns makes no difference when you are not withdrawing from your investments. However, once you start to decumulate from your portfolio, the order of your returns can have a significant impact on your portfolio balance. I’ll borrow the following graphic from a previous article to highlight the impact of 10 years instead of just 3. Now imagine it over a 30 year retirement? It’s certainly a risk you need to manage.

 

 

 

Now that we have acknowledged and understood the risk this represents, just what can you actually do about it?

 

Well, the good news is that a properly built portfolio can actually handle and mitigate this risk so long as you are comfortable with a fluctuating asset allocation throughout retirement. The problem is most people’s portfolios aren’t built properly. I’m sorry, but your balanced mutual fund or all in one etf is terrible for mitigating this risk. The all in one etf can be great for the accumulation phase, but terrible for the decumulation phase.

 

Let’s look at a 60/40 stock and bond portfolio with a 4% withdrawal goal, from starting capital of $100,000. First, let’s look at a balanced mutual fund, then we will unpack the balanced fund and show you how to mitigate the sequence of returns risk.

 

 

RIght, so your balanced fund has $100,000 in it. The stock market drops 30% and the bond market stays stable. This causes your balanced fund to drop 18% (30% * 60% = 18%). If you withdraw your $4,000 you are technically withdrawing 60% from the stock portion and 40% from the bond portion. Resulting in your withdrawal coming from a base that is 18% lower. You have no control over this as the manager is generally required to have a fixed range of acceptable asset allocations and would be forced to meet withdrawals with a proportional mix from stocks and bonds. This leaves you completely at the mercy of the sequence of your returns.

 

Now, what if you broke apart your balanced fund and actually directly owned 60% stocks and 40% bonds in this same scenario?

 

 

Well your $60,000 in stocks have dropped 30% to $42,000, but your bonds have stayed at $40,000. Now, when it comes time to withdraw your $4,000 where do we want to sell it from? Do we take it proportionately while the market is down 30%, or do we strategically withdraw from your bond holdings since they aren’t down in value? That’s right, we withdraw from the asset class that is positive or in this case flat in value.

 

This results in you not actually having to sell from the stock market during times of crisis, you only withdraw from your safer portion and ensure you give yourself enough time to allow the market to recover.

 

The key to this strategy is twofold. First, you have to be comfortable with a varying asset allocation. After all, a severe stock drop could last more than 5 years. Causing you to have to withdraw $4,000 per year from your bonds for a total of $20,000. Leaving you with $42,000 in stocks still and now only $20,000 in bonds remaining. This shifts your asset allocation from 60% stocks to 68% stocks. If the stock market stays down for another 5 years, you would effectively be 100% in the stock market. A possibility many are not willing to take.

 

Secondly, you need to have enough of your money in safer asset classes that you can ride out a stock market drop of anywhere from 5 to 10 years depending on your level of safety required. For example, if you only keep 30% of your portfolio in safer assets and draw 5% per year, you would run out in 6 years and be forced to access money from the stock market. There have been multiple bear markets that took more than 6 years to recover.

 

Being aware of this strategy is paramount. Understanding and being willing to allow your portfolio asset allocation to shift, in order to reduce the sequence of returns risk is essential to this being an effective strategy. Otherwise, you simply have to take the risk and suffer the consequences of the order of your returns dictating the success of your retirement strategy.

 

The choice is yours, but the more informed you are as an investor, the most successful your retirement can be.