For years we have heard it repeated over and over from the financial sector – and their willing allies in academia and the media – that investing in stocks will provide us the best possible returns over time.
In a recent post, I pointed out that one of the problems with this conventional wisdom is how one defines “over time.” Depending on when you invest, how long you stay invested, and the time frame in which you need your money back, can have a dramatic impact on your actual results.
But the difficulties don’t end there…
The risk of Sequence of Returns
This problem relates to the “sequence” or the order in which a person receives his or her investment returns while withdrawing funds from a portfolio during retirement.
It is an enormous concern, though few people have any idea it exists.
It is both uncontrollable and unpredictable, and, depending on how it plays out, it can lead to a the early depletion of person’s retirement fund.
Here’s how it works.
Consider the following three numbers:
-13, 7, 27
Add them up and you get 21.
Divide 21 by 3 and you get an average of 7.
This is called an “arithmetic average.” Similarly, the oft quoted “7% inflation adjusted rate of return including dividends on stocks over time” is an arithmetic average.
You can add the three numbers above in any “sequence” you like and you’ll still get a total of 21 and an average of 7.
-13 + 27 + 7 = 21. (21 divided by 3 = 7)
7 + -13 + 27 = 21. (21 divided by 3 = 7)
27 + 7 + -13 = 21. (21 divided by 3 = 7)
But, here’s the rub…
The order in which those numbers appear as “returns” in a person’s portfolio can have a major impact on how long his or her portfolio lasts during retirement.
Let’s take the same three numbers: -13%, 7%, 27%, and apply them in different orders as rates of return on a portfolio that is funding systematic withdrawals – just as would be the case for someone funding his or her retirement.
- We’ll start with a $100 nest-egg and take $10 out of the portfolio each year to pay bills.
- We’ll run two sequences, both with 7% average returns.
- The only difference between the two scenarios is the sequence or the order in which the returns are achieved.
In Sequence One, the order of returns will be: -13% in year one, 7% in year two, and 27% in year three. The returns will continuously repeat for a running average return of 7%.
In Sequence Two, the order of returns will be: 27% in year one, 7% in year two, and -13% in year three. The returns will continuously repeat for a running average return of 7%.
Let’s see what happens…
Sequence Two ends up yielding 44% more income than Sequence One (i.e. $168.37 versus $116.81) and lasts five years longer.
This happens with exactly the same $100 nest egg, exactly the same rate of withdrawal, and exactly the same long-term average rate of return.
The only difference is the unpredictable and uncontrollable sequence of returns.
These examples show that a difference in the order of returns – notably, more negatives in the early years just before or just after retirement begins – can have a dramatic impact on how long a person’s retirement money will ultimately last.
So, what do you think?
- Have you ever heard of the risk of “sequence of returns” before?
- With tens of millions of people in 401(k) type plans that may be affected by this concern, why don’t we hear more people talking about it?
- Does the example above illustrate the concept clearly enough?
- What other issues does becoming aware of this risk bring to mind? (I’ll tell you one – women are the most at risk because they live substantially longer than men…)
Email me your thoughts or comment below.