Sequence Risk

[Hopeful]

I realize there has already been a lot of discussion on sequence of return risks, but I wanted to discuss some aspects of sequence risk that keeps bouncing around in my head.

My DW and I have hit a number that we “should” feel confident that we could RE. FireCalc says we are 100%. But as many have we play the one more year game in case our spending isn’t what we think, we want more fun money, health issues etc. DW and I have drastically reduced our work hours, and DW works just enough to get health insurance. The plan that we are comfortable with now is to completely RE in 2 years as this would allow her to take advantage of her employers rule off 55, and allow for a few more years of growth.

That is where the sequence of return keeps “haunting” me. Sure FireCalc shows 100% now, but with the market at an all time high who knows what 2 years is going to bring. I realize that FireCalc is currently factoring all previous sequences in when spitting out the 100% number, but what if there was a major downturn over the next two years? If the market was down 30-40% 2 years from now, and FireCalc no longer showed a 100%, I wouldn’t feel so confident.

I realize a lot of this is just mind games as we get closer to RE. I also realize that I shouldn’t rely only on FireCalc. It is just as RE comes closer and closer, sequence risk seems to loom more over my head. Sorry if this makes little sense, but i just wanted to vent a little.

 

[njhowie]

Your thoughts are valid and prudent. Don't be swayed by those who will advise looking through rose-colored glasses, accepting Firecalc of 100% at face value. It's good to consider what could happen and have enough saved with the proper AA to weather whatever might occur.

If you are stressed or lose sleep considering what might happen, then you likely do not have enough saved, or have an AA which is too aggressive for your intended lifestyle.

 

[Dtail]

You can play around with Firecalc as to the minimum portfolio one must have and still show a 100% success rate.
Then depending on your AA, you can calculate the maximum % downturn in the market and still achieve 100% success.
Perhaps this will make you more comfortable hopefully.

 

[Hopeful]

Your thoughts are valid and prudent. Don't be swayed by those who will advise looking through rose-colored glasses, accepting Firecalc of 100% at face value. It's good to consider what could happen and have enough saved with the proper AA to weather whatever might occur.

If you are stressed or lose sleep considering what might happen, then you likely do not have enough saved, or have an AA which is too aggressive for your intended lifestyle.

I have thought of changing my AA. Currently at 65/35 but wouldn't really want to go below 60/40 with such an early retirement though. Plus I am running out of tax deferred space to make allocation changes. I think I would have to sell taxable at this point to make any further changes.

The not having enough saved is what does "keep me up at night". Though as other's on here have pointed out in the past, that may be more of an issue of my own anxiety than not actually having enough. Many here would have made the leap long ago.

 

[Navigator]

Your concerns are legitimate. Firecalc uses historical data to tell you what would have happened if you had retired in the past. However, markets and financial regulations today are very different than they were in the 1920s, 1950s and the 1980s. There is no guarantee markets in the future will behave like they did in the past.

What can you do? IMHO, having flexibility in spending is the key to a financially worry-free retirement. I created a normal budget that included what I would like to do in retirement, including things like overseas travel and huge spending on scotch. I then created a bare-bones budget that eliminated many excesses, but still allowed for a reasonable retirement. My bare bones budget is a bit over half of my normal budget, so if my portfolio dropped by say 40%, I know I would still be okay.

 

[OldShooter]

I don't pay a lot of attention to AA as a guide. What I want to have is enough money on the fixed side (it's mostly in TIPS) to weather a downturn on the equity side. This may preclude rebalancing but its quite a comfortable strategy for us. FWIW, our resulting AA is 75/25.

Our backup to this backup is, as @Navigator suggests, flexible spending. Our spending currently includes large amounts for charity and for international travel. Both would be easy to cut and as we become more decrepit the travel will probably go down on its own.

A point that people tend to forget, too, is that after a downturn the market recovers. There are no rules that preclude selling equities prior to recovering to its exact previous peak. In the unlikely event that our fixed stash runs low we still will have bridged the majority of the recovery time, so selling equities will not be all that painful.

 

[Hopeful]

I agree with what everyone has pointed out as to flexibility. I think our plan has enough discretionary spending to weather a downturn. Our current AA of 65/35 has enough for 10 years of spending on the fixed income side.

The thing that bothers me is if the downturn happened just preceding RE, I can see us getting farther into that one more year hole.

 

[Mountain skier]

If I may ask- what are your ages?

 

[OldShooter]

... Our current AA of 65/35 has enough for 10 years of spending on the fixed income side. ...

IMO you're golden. I would even argue for a more aggressive AA, but that is a personal comfort thing.

 

[Hopeful]

if i may ask- what are your ages?

47 & 53

 

[Mountain skier]

By your age I see your concern. I do like fact you have 10 years of fixed $ set aside- hopefully cash

 

[njhowie]

The thing that bothers me is if the downturn happened just preceding RE, I can see us getting farther into that one more year hole.

Better it should be just preceding where you still have the flexibility to potentially wait longer to retire, and save more, rather than it happen just after when you begin spending down your investments into the downturn.

 

[corn18]

We mitigate SORR with a flexible budget. We looked at our budget and set a floor @ $90k / year. Our target spending is $140k / year. We can handle a 60% drop in equities (60/40 portfolio) and still be above the floor. By definition, a 60/40 portfolio has 10 year of cash @ 4% withdrawal rate, so that works, too.

 

[ERD50]

.... That is where the sequence of return keeps “haunting” me. Sure FireCalc shows 100% now, but with the market at an all time high who knows what 2 years is going to bring. I realize that FireCalc is currently factoring all previous sequences in when spitting out the 100% number, but what if there was a major downturn over the next two years? ... Sorry if this makes little sense, but i just wanted to vent a little.

Well, you actually did answer your own question in that statement. FIRECalc takes that downturn into account. That's how you get 100% - with that downturn!

Sure, future could be worse then the worst of the past, but at 100% historical success, you are in good territory. If you want guarantees - work till the day you die!

BTW, I'm pretty sure the whole idea of keeping a 'safe' AA for 5~7 years to avoid Sequence of Returns Risk doesn't pan out. To test it (and I may have done this in the past, I may look for the data later), you would need to take your 'safe AA', and do a 5~7 year FIRECalc run. Take the lowest end value, and now run FIRECalc again with a 75/25 AA for your desired portfolio length minus those 5~7 years.

Remember, the major downturns occur after bull runs. I think what you will find is that hitting that downturn after you were 'safe', meant you didn't fully participate in the preceding bull. So having that downturn hit after you were playing it 'safe' may b as bad or worse than just hitting the downturn in the first year.

No place to run to, no place to hide?

..... By definition, a 60/40 portfolio has 10 year of cash @ 4% withdrawal rate, so that works, too.

It's actually better than that. If your portfolio is kicking off say 2% in divs, you only need to sell off 2 points of your fixed side each year. Simple math says that's 20 years, but it would be something less, because your stash, and divs, are dwindling as you sell. But something more than 10 years and less than 20 years before you need to sell a single $ on the equity side.

-ERD50

 

[COcheesehead]

Google Kitces’ raising equity glide path and “bond tent”. You may find it of value.

 

[ERD50]

We mitigate SORR with a flexible budget. We looked at our budget and set a floor @ $90k / year. Our target spending is $140k / year. ...

I also think people overstate the value of a flexible budget.

I've done some tests on this in the past - it takes a huge reduction in spending, and it must happen early, in order to have much affect on survive-ability.

Look at the last downturn. We peaked ~ October 2007. Then had about 4 dips with some recovery, out to ~ August of 2008. So do you cut back then (and take a hit in lifestyle)?
Or do you say that we are just 15% below a recent peak, carry on?

When do you cut? A few months later, we are down ~ 30% from the peak. Is that the time to cut? A year later, we've recovered to that point. In about another year, we are back to within 15% of the peak.

Do you really think cutting expenses by 35% for a few years is going to have much influence on that? You could actually plug those numbers into www.portfoliovisualizer.com/backtest-portfolio to test it. I doubt it has much effect at all. But I bet that cutting $50,000 out of your annual budget means missing out on some good times. And for some of us, that may be time we can never get back.

The whole point of a conservative WR is that it will survive those downturns without cutting spending.

Now if you chose a much looser WR, with the intention of cutting back, that might work out in some ways. But we can never know if the downturn is worse than any in history until after the fact.

-ERD50

 

[Gumby]

To add to what ERD50 says, to the best of my knowledge, FIRECalc assumes that you will draw from your portfolio every year in proportion to its composition. That is, if you choose a 60/40 allocation, every year you'll draw 60 percent of spending from your equities and 40% from fixed income. So, yes, it already anticipates that you will be selling equities in a downturn.

 

[ERD50]

To add to what ERD50 says, to the best of my knowledge, FIRECalc assumes that you will draw from your portfolio every year in proportion to its composition. That is, if you choose a 60/40 allocation, every year you'll draw 60 percent of spending from your equities and 40% from fixed income. So, yes, it already anticipates that you will be selling equities in a downturn.

I would assume (but we can't know w/o seeing the code, or maybe dissecting the spreadsheet output), that because FIRCalc also re-balances every year, that it would perform the withdrawal in conjunction with a re-balance, so no, you would not be selling equities in a downturn.

Otherwise, it would be selling 60/40 for the withdrawal, and then saying (if FIRECalc could talk!) - "Oh, I need to re-balance now, so I'll sell some more bonds and buy more stocks. But I just sold stocks for the withdrawal?"

I guess either way, it would be buying them at the same price it sold, so it would be a wash (but not a tax wash, as FIRECacl doesn't do taxes), and effectively NOT selling stocks in a downturn in either case.

-ERD50

 

[Andre1969]

I wonder if this would work?

Try running a sequence where you have, say, a 40% loss the first year. Basically, run your numbers again, but with 60% of your portfolio balance, but a duration of one less year. For example, if your 100% success rate has a starting balance of $2M, and you need it to last 40 years, what does it look like if you put in a starting balance of $1.2M, and 39 years?

I'm sure there are some flaw in this strategy, though. For instance, I was down 5.4% in 2000, 24.8% in 2001, and another 20.8% in 2002. So I'd presume that going through this strategy, it would mean a cycle where I lost 40% the first year, then 5.4% on top of that, then 24%, and then 20.8? So a serious down year, followed by a slight down, followed by two more serious down years. I don't know if there's been a period in history that's been quite that bad?

Even in the Great Depression, I don't think it got that bad. From what I recall reading, there was actually a pretty big comeback in 1932, but then 1933-34 were down years?

But, even if the market is down by 40%, your portfolio probably wouldn't be, depending on your asset allocation.

Also, while 2000-2002 was a bad timeframe for me, I was pretty aggressively invested...very little in conservative stuff. I was (and still am) working, and retirement seemed a long ways off, so I figured I could afford to stay invested that way. Same for the 2008 hit, where I lost about 41% that year. If I was retired, I wouldn't be nearly so aggressively invested.

 

[Gumby]

I would assume (but we can't know w/o seeing the code, or maybe dissecting the spreadsheet output), that because FIRCalc also re-balances every year, that it would perform the withdrawal in conjunction with a re-balance, so no, you would not be selling equities in a downturn.

Otherwise, it would be selling 60/40 for the withdrawal, and then saying (if FIRECalc could talk!) - "Oh, I need to re-balance now, so I'll sell some more bonds and buy more stocks. But I just sold stocks for the withdrawal?"

I guess either way, it would be buying them at the same price it sold, so it would be a wash (but not a tax wash, as FIRECacl doesn't do taxes), and effectively NOT selling stocks in a downturn in either case.

-ERD50

Let's run a hypothetical and see:

Assume portfolio of $1 million at Year 0 - $600k stock and $400k bonds at .5%

After one year, stock market drops 5% - $570k stock and $402k bond = $972k total (58.6/41.4)

Now draw $40k, which is 4.115% of the total portfolio.

Assume it comes proportionately (58.6/41.4) - $23.5 from stocks and $16.5 from bonds

Now the total balance is $932k - $546.5 stocks and $385.5 bond

Now rebalance to (60/40) $559.2 stocks and $372.8 bonds, which will require selling $12.7k of bonds and buying $12.7k of stocks.

This results in a net sale of $10.8 stocks in a down market

OR, let's assume you rebalance first and then fund the yearly draw

So, at Year 1, total is now $972k (570 stock/402 bond). To get back to 60/40, you need to sell $13.2k of bonds and buy $13.2k of stock => Now you have $583.2 of stock and $388.8 of bonds. Now draw $40k in 60/40 proportion => $24k from stocks and $16k from bonds.

This also results in a sale of $10.8 of stocks in a down market (+ $13.2k to rebalance, - $24k to fund yearly draw.)


Same result either way. You will end up in the net position of having sold stock in a down market.


EDIT TO ADD:

I ran a few more scenarios and found that with the beginning conditions above, for any stock market drop above 9.5%, one would be a net buyer of stocks. Any drop less than that would still result in the sale of some stock in a down market.

 

[audreyh1]

To add to what ERD50 says, to the best of my knowledge, FIRECalc assumes that you will draw from your portfolio every year in proportion to its composition. That is, if you choose a 60/40 allocation, every year you'll draw 60 percent of spending from your equities and 40% from fixed income. So, yes, it already anticipates that you will be selling equities in a downturn.

That is not correct at all.

I have a 30% equities gain year and bonds are up 4%. I am now at 65/35. I’m going to take all my 4% withdrawal from equities which drops me down to 64/36 of the remaining portfolio. I still need to rebalance so I sell even more stocks and buy more bonds to get to 60/40. Another 4% in fact of the portfolio gets pulled from stocks and put into bonds to get back to 60/40.

Similar on the downside. Equities are down 30%. Bonds up 10%. I am now at 49/51. I take all my 4% withdrawal from bonds. I am now at 51/49 of the remaining portfolio. I still have to sell a big chunk of bonds and buy stocks to get back to 60/40. That’s actually another 9% of the remaining portfolio going from bonds to stocks.

I think people who say they only need 5 or 7 years in fixed income to ride out a down market don’t appreciate how much of their fixed income may be used to rebalance back to their target AA.

 

[Gumby]

That is not correct at all.

I have a 30% equities gain year and bonds are up 4%. I am now at 65/35. I’m going to take all my 4% withdrawal from equities which drops me down to 64/36. I still need to rebalance so I sell even more stocks and buy more bonds to get to 60/40. Another 4% in fact of the portfolio gets pulled from stocks and put into bonds to get back to 60/40.

Similar on the downside. Equities are down 30%. Bonds up 10%. I am now at 49/51. I take all my 4% withdrawal from bonds. I am now at 51/49. I still have to sell a big chunk of bonds and buy stocks to get back to 60/40. That’s actually another 8.7% of the remaining portfolio going from bonds to stocks.

See the scenario in the next of my posts.

PS - that may be how you do it, but that doesn't mean it is the assumption in FIRECalc.

 

[OldShooter]

... I think people who say they only need 5 or 7 years in fixed income to ride out a down market don’t appreciate how much of their fixed income may be used to rebalance back to their target AA.

Well, in my case I really don't have a target AA. I have a target $ amount for non-equities. Our 75/25 is just a consequence.

That said, I did sell some equities when we got to 80/20 and thus have a little "unneeded" cash to buy if equities take a dive. The the amount I buy will be limited by my target non-equity $ number and not by any AA numbers.

To your point, a book I read once described a theoretical case of rebalancing post-1929 and the resulting portfolio went from years of "safe" money to months as the safe money was used to rebalance. I don't see that anyone would actually do that. In the end it seems like people would revert to my approach. After all, as William Bernstein points out, the objective of the exercise is not to get rich; it is to not get poor.

 

[audreyh1]

See the scenario in the next of my posts.

PS - that may be how you do it, but that doesn't mean it is the assumption in FIRECalc.

The FIREcalc spreadsheet shows the percentages and withdrawal amount based on the total portfolio value and the end results. But to actually implement it, you have to sell some assets to cover the withdrawal as well as selling and buying more assets to rebalance. It can be all calculated as a single step which is what I actually do, but assets will be sold based on how out of balance they are from your target, not based on the resulting AA.

Now some folks might rebalance and then withdraw proportionally, but it makes far more sense to do it all at once and calculate the rebalance after the withdrawal is removed, otherwise you’ll buy one of the asset classes and turn around and immediately sell it again to meet your withdrawal. Certainly not practical in a taxable account. I don’t think you can claim it’s proportional selling when you choose to rebalance before doing the withdrawal, because the rebalancing certainly wasn’t proportional.

 

[audreyh1]

Well, in my case I really don't have a target AA. I have a target $ amount for non-equities. Our 75/25 is just a consequence.

That said, I did sell some equities when we got to 80/20 and thus have a little "unneeded" cash to buy if equities take a dive. The the amount I buy will be limited by my target non-equity $ number and not by any AA numbers.

To your point, a book I read once described a theoretical case of rebalancing post-1929 and the resulting portfolio went from years of "safe" money to months as the safe money was used to rebalance. I don't see that anyone would actually do that. In the end it seems like people would revert to my approach. After all, as William Bernstein points out, the objective of the exercise is not to get rich; it is to not get poor.

Well that’s why I have a 50/50 AA, besides other volatility/end point characteristics, I also have plenty of room to both withdraw AND rebalance. I do have a lower $$ bound for fixed income.