Understating Sequence of Return Risk

[jkern]

While driving the other day, I was casually listening to the Rick Edelman show on the radio. Similar to many financial shows, he promotes investing in stocks & bonds. Due to the recent market drop, he was quoting long term Average Annual Rates of Return to bolster his view. He quoted numbers from 1926 and other cherry picked start and stop dates.

This got me thinking that the Rick Edelman's of the world rarely if ever mention sequence of return risk. Even when they do mention it, I believe they significantly understate its importance on the final outcome of your portfolio.

So, given the amount of free time I have, I calculated my own Ave Annual Rate of Return during my accumulation phase (1987 to June 2009). It equals approximately 2.5% with mostly a 80/20 stocks/bonds portfolio. It appears the sequence of returns is by far the largest factor on a portfolio during the accumulation phase and probably the withdrawal phase too.

Does anyone else feel the same way or am I missing something?

[Midpack]

Sequence of returns alone is far more significant during the distribution/withdrawal phase, not so much during accumulation, and not at all for a fixed amount. But sequence of returns is but one of many variables, with potentially bad or good outcomes. At least with calculators like FIRECALC and others that use actual market history, a variety of sequences is built in - though there's no guarantee there won't be better or worse sequences to come.

There's quite a bit published analyzing the role of sequence of returns of you're interested.

[audreyh1]

Yes - many folks here plus some writers like Kitces and Bernstein take sequence of return risk very, very seriously. Kitces has some interesting strategies to deal with it.

Many folks here recognize that the first 10 years of retirement are the go or no go years in terms of portfolio survival. Some of us mitigate it by being willing to ratchet down spending if faced with a declining portfolio, and/or taking out less that the supposed "safe" withdrawal percentage. It definitely helps if you have discretionary spending you can cut back on.

Right - like Midpack it is an issue during retirement, not while saving for retirement unless you don't have the flexibility to decide when you quit work.

[RetireAge50]

Your low return is due to the stock market crash not the sequence of returns. Unless you sold at that point then your portfolio recovered. The sequence of return risk has to do with selling stocks during low market phases at the beginning of the withdrawal phase. To moderate this risk you must adjust your spending dramatically lower during this time or keep part of your portfolio out of stocks (which adds inflation risk and opportunity lost).

[utrecht]

The SP500 averaged abut 8.5% per year from 1/1/87 - 6/1/09. If your 80/20 portfolio only returned 2.5% you did something seriously wrong.

[jkern]

Quote:

Originally Posted by RetireAge50 Your low return is due to the stock market crash not the sequence of returns. Unless you sold at that point then your portfolio recovered. The sequence of return risk has to do with selling stocks during low market phases at the beginning of the withdrawal phase. To moderate this risk you must adjust your spending dramatically lower during this time or keep part of your portfolio out of stocks (which adds inflation risk and opportunity lost).

The stock market crash at the end of my accumulation phase vs. the beginning had a major effect on my ending balance. Maybe this term has only been used during the withdrawal phase, but the sequence of returns during the accumulation phase plays a large role in how much you can accumulate too. Yes, I know a person can keep working and accumulating if desired.

I was generally referring to FA or others quoting high Ave ROR during the accumulation phase to promote investing in the market. These numbers can be very misleading and your ending number is extremely dependent on when the bulls and bears occur.

[jkern]

Quote:

Originally Posted by utrecht The SP500 averaged abut 8.5% per year from 1/1/87 - 6/1/09. If your 80/20 portfolio only returned 2.5% you did something seriously wrong.

The issue is that I dollar cost averaged into the market over the entire accumulation phase. If I had a lump sum at the beginning, yes I would have averaged 8.5%. That's my point, the sequence of returns reduced my average rate of return during this phase.

[foxfirev5]

Fancy schmancy. The old school rule of thumb was buy low sell high. Always has been and always will be true. Applying various formulas and backtested results really don't have anything to do with the future.
Diversify, make your best guess and hope for the best.

[samclem]

Yes, sequence of returns matters during the accumulation phase, too. Here's a paper on that. From the paper:

Quote:

Meet some pretend employees, Joe and Jane. They worked for Acme, Inc., and were identical in essentially all aspects of their job, their salary, and their participation in their company’s defined contribution retirement plan (a “typical” 401(k)). Here are some key dimensions to consider: Identical length of time working: Both started working at 25, and both worked for 40 years. Identical starting salary and salary growth.1 Identical deferral rates and identical company match2 for a combined 9% annual contribution. Identical investments: Both invested in a typical target date fund (TDF), which started out with a 90% equity allocation, and glided down to below 50% by retirement age. Identical returns: This is a key point. During their 40 years of investing, they both earned exactly 5% annualized real (above inflation, or roughly 8% nominal) after fees. Identical in virtually every way. At the end of their 40-year careers, however, Jane had $880,000 in her account, while Joe had $590,000. How is this possible? Who ate $290,000 of Joe’s retirement money? How do you explain a 50% gap between these two employees? The answer? Sequence risk. Here’s what we didn’t tell you. Joe started his career in 1954, while Jane started in 1967, 13 years later. So, even though Joe earned the same annualized return as Jane, he earned it in a slightly different sequence, and that made all the difference.

As the pot gets bigger and retirement (and withdrawals) gets closer, it can be appropriate for many retirees to gradually change their allocation to something with a bit less volatility. After withdrawals get underway, if the portfolio grows a bit they can handle more volatility (their withdrawals won't push the balance down to the X-axis) and they can afford to increase their stock holdings--if they want to.

[audreyh1]

Quote:

Originally Posted by RetireAge50 Your low return is due to the stock market crash not the sequence of returns. Unless you sold at that point then your portfolio recovered. The sequence of return risk has to do with selling stocks during low market phases at the beginning of the withdrawal phase. To moderate this risk you must adjust your spending dramatically lower during this time or keep part of your portfolio out of stocks (which adds inflation risk and opportunity lost).

You aren't going to be selling stocks when the equity market is low unless you started out with 80%+ in stocks.

The studies model various portfolios of X% stocks and Y% fixed income. Those with sufficient fixed income % can draw on the fixed income portion for a few years without having to sell stocks. If they are rebalancing (as the models do) they would actually be buying stocks after a crash.

The real killer in the series is high inflation coupled with poor stock market performance which means an inflation adjusted withdrawal keeps pulling more and more out of the portfolio, not letting it recover.

[audreyh1]

Quote:

Originally Posted by samclem Yes, sequence of returns matters during the accumulation phase, too. Here's a paper on that. From the paper: As the pot gets bigger and retirement (and withdrawals) gets closer, it can be appropriate for many retirees to gradually change their allocation to something with a bit less volatility. After withdrawals get underway, if the portfolio grows a bit they can handle more volatility (their withdrawals won't push the balance down to the X-axis) and they can afford to increase their stock holdings--if they want to.

In that scenario, the Joe can keep working until his pot matches Jane's. In the real world people work until their nest egg is big enough to retire. A market crash can add a few more years to work, and definitely has for many folks!

[CaliforniaMan]

I think a good way to look at sequence of returns importance is how far it is from the present. When in the accumulation phase, the latest year always had the largest effect, since it affects the entire portfolio, all your contributions and gain up until now.
When in the withdrawal phase, the most recent year is also always the most important, since that also affects your entire pot going forward.
As you go back in time, or forward in time, the relative importance of the return diminishes. So as far as sequence of returns goes, the most recent years are always the most important. The weights fall off into the past and into the future.
And keep in mind during the withdrawal phase, that the sequence of returns risk is always there, this year is always year zero.

[jkern]

Quote:

Originally Posted by samclem Yes, sequence of returns matters during the accumulation phase, too. Here's a paper on that. From the paper: As the pot gets bigger and retirement (and withdrawals) gets closer, it can be appropriate for many retirees to gradually change their allocation to something with a bit less volatility. After withdrawals get underway, if the portfolio grows a bit they can handle more volatility (their withdrawals won't push the balance down to the X-axis) and they can afford to increase their stock holdings--if they want to.

Thank you. This is what I was referring to during the accumulation phase. I guess it just irks me when the talking heads talk about investing for retirement and quote long term average rates of return and don't mention return sequence. It has everything to do with your ending balance at retirement.

[audreyh1]

Quote:

Originally Posted by jkern Thank you. This is what I was referring to during the accumulation phase. I guess it just irks me when the talking heads talk about investing for retirement and quote long term average rates of return and don't mention return sequence. It has everything to do with your ending balance at retirement.

But if you have a goal of how large a nest egg to retire with, rather than a target age or year, you can retire when that ending balance meets your goal. If you are trying to target a given year or age you might need to transition to a more conservative allocation so that a sudden market drop doesn't set your retirement plans back a couple of years or so. But that also sacrifices performance if there is NOT a crash, so it could also extend the years working.

Most early retirees are able to retire early because their nest egg meets their goals. Otherwise, they keep working.

[jkern]

Quote:

Originally Posted by audreyh1 In that scenario, the Joe can keep working until his pot matches Jane's. In the real world people work until their nest egg is big enough to retire. A market crash can add a few more years to work, and definitely has for many folks!

That's my point. The return sequence is so important that Jane gets to retire and Joe is still working. It just seems to be understated and brushed off.

[foxfirev5]

Yes, a long run of mediocre returns after an early run up really does nothing to help an individual in the accumulation phase. Often ignored but a very possibility.

[jkern]

Quote:

Originally Posted by audreyh1 But if you have a goal of how large a nest egg to retire with, rather than a target age or year, you can retire when that ending balance meets your goal. If you are trying to target a given year or age you might need to transition to a more conservative allocation so that a sudden market drop doesn't set your retirement plans back a couple of years or so.

My goal was to accumulate enough to retire, not necessarily a target number or specific date. I was merely pointing out that return sequence may have a greater impact on your ending portfolio (retirement date) than ave rate of return. Most of the financial show host's usually only talk about ave rate of return.

[audreyh1]

Quote:

Originally Posted by jkern That's my point. The return sequence is so important that Jane gets to retire and Joe is still working. It just seems to be understated and brushed off.

You can't really do anything about it though. What do you do? You save a ton and invest as best you can. Some decades the more conservative investor will be rewarded, others the more aggressive investor will be rewarded. You work until your nest egg meets your goals, or you settle for a less generous retirement if you can't stand to work anymore. At least while you are working you usually have the option of continuing to work and save. Once you retire and start drawing on your nest egg you have much less flexibility.

[audreyh1]

Quote:

Originally Posted by jkern My goal was to accumulate enough to retire, not necessarily a target number or specific date. I was merely pointing out that return sequence may have a greater impact on your ending portfolio (retirement date) than ave rate of return. Most of the financial show host's usually only talk about ave rate of return.

I agree that the financial show hosts aren't that helpful beyond the very basics.

But for most ERs the retirement date is determined by when their portfolio meets their goals - however long it takes to get there, not the other way around (whatever the portfolio is the date they had predetermined to retire).

I remember well. I had a few years where I felt like I was holding my breath. 1997 was pretty scary when I was really, really hoping I would be able to retire in 1999. For a while it looked like I might have to work longer than planned, but things recovered quickly and ended up exceeding my goals when I retired.

Then - retiring in 1999 - guess what? I met the mother of all nasty return sequences. Well - maybe it wasn't the mother of all, but it was pretty bad. Fortunately the way my investments were set up I wasn't hit nearly as hard as I might have been.

Many people do tend to retire after several good years in the markets when their nest egg grows quickly - so a sweet sequence of returns during the accumulation phase, but ironically they are then a somewhat more likely to encounter a poor sequence of returns shortly after retiring.

[samclem]

Quote:

Originally Posted by CaliforniaMan I think a good way to look at sequence of returns importance is how far it is from the present.

It's true. But if we have a set number of years and if a person isn't making withdrawals >and isn't contributing<, the sequence of returns during that time period has zero impact on the value of their portfolio at the end of the period. That's illustrated in the .pdf here.

During the accumulation phase (when contributions are being made), bad returns in the very early years have very little impact, because the growth in portfolio value is going to increase a lot regardless due to the next year's contribution--the growth of the balance is determined primarily by contributions. Not so in much later years, as growth of the balance depends much more heavily on investment returns.