If you are going to retire and attempt to live off the returns from your investment portfolio, you should be familiar with something called “sequencing of return” risk. What this means is that while over a long period of time, say 25 years, you may get good returns in your portfolio, if they come in the wrong order, you can still run out of money.
I’ll give you a simple example to illustrate the issue. Let’s assume you have a 25-year period where your average return is 5% for those 25 years. Now let’s assume you wanted to withdraw 4% of your portfolio every year for those 25 years. Shouldn’t be a problem since you earned 5% and withdrew 4%.
But depending on how you got your 5%, you can see wildly different results. When doing planning most people just plug in 5% a year, withdraw 4%, and it all looks good. But financial asset returns are never that smooth. In fact they can be extremely volatile. And the more volatile they are, the higher the odds are that you’ll run out of money.
Let’s start with a $1 million portfolio and withdraw 4% each year adjusted for inflation. But instead of assuming you got 5% each year, let’s assume you got 0% each year for the first half of those 25 years years and then 10% a year for the second half, for a simple average of 5%. How would you have done? Well, you would have run out of money in year 21. That might be surprising to learn given your return over the entire 25 years was higher than your distribution rate.
The problem is the sequencing (or order) of returns. If you retire and hit a bad decade right off the bat, you are taking out money while there are no gains, so your principal value keeps falling. And once you do start seeing better returns later in your retirement, you don’t have enough money left for those returns to repair your portfolio.
Now, what if we reverse the order of the returns, meaning in the first half of that 25 years you got 10% a year and in the last half you got 0%. Instead of being out of money in year 21, you would have about $1.4 million in your portfolio. Quite a different result all because of the issue of sequencing of returns.
So when you go to retire, you want to think about the sequencing of return risks. The risk posed by the sequencing of the returns can be more important than your actual return over the period of your retirement. That means you should also design a portfolio to address these issues. If your portfolio strategy doesn’t take this into account, you may find that your “paper” returns aren’t adequate to support your real world spending needs.
If you think it’s unusual for markets to have a 0% return for 10 years, we just went through a period from 2000 to 2010 where there were no returns in the stock market (not to mention the two big crashes we had during that decade). So it can and probably will happen again.
Disclosure: Above material is for information and education purposes only. Past performance is not indicative of future returns. There can be no assurances that any distribution rate is supportable by a portfolio. All investing involves the risk of permanent losses. Illustration assumes a 2% inflation rate on distributions, and a 0% return for the first 12 years for the first scenario, and a 10% return for the first 12 years in the second scenario.