Does Sequence of Returns Math Upend Timing the Market?

A look at how variable rates of return do (and do not) impact investors over time. 

Financial headlines are comparing the markets to a roller-coaster, with their regular dips and upturns.  Investors remember 2008 and might be concerned about the market direction and the safety of their retirement accounts.    These are the people that are white-knuckling it through the 5 G-Force ups and downs of the thrill ride, while trying to hold their stomach.  Sounds like fun, right? 

Truth is, I love theme park roller coaster rides, still.  My husband is a little older, and he used to love doing those rides with me.  Now, I peek over and he’s gripping for dear life, the blood is drained from his face and he’s got a death grimace of pain through every turn.  He doesn’t want to admit that his fast and furious days are behind him.  He’d be much more content on a slow moving ride such as ‘It’s a Small World’.   

Truth is, things change as we get older.  Our appetites for adventure shift in both entertainment and in investing.  We are more apt to be indifferent to the peaks and valleys of the stock market when we are much further from retirement.  Later in life, we tend to keep an eye on our portfolio values much more as we get closer to needing to tap into those financial assets.

Those close to retirement that can no longer stomach the market volatility have great instincts.  If they think it’s time to get off the ride, they may be right.  But not for reasons that they think!

See, it’s not about timing the market. We all know markets go up and down.  Nothing can stop that.  And, despite what anyone may tell you, no-one can accurately predict 100% the market directions. What’s actually important is the “sequence of returns”.

 What exactly is the “sequence of returns”? The phrase simply describes the yearly variation in an investment portfolio’s rate of return. Across 20 or 30 years of saving and investing for the future, what kind of impact do these deviations from the average return have on a portfolio’s final value?

The answer: no impact at all.

That’s why it’s not recommended that a younger investor try to time the market.  With a longer time-horizon until retirement, they are better positioned for the market ride.

But, once an investor retires, however, these ups and downs can have a major effect on portfolio value – and retirement income.

During the accumulation phase, the sequence of returns is ultimately inconsequential. Yearly returns may vary greatly or minimally; in the end, the variance from the mean hardly matters. (Think of “the end” as the moment the investor retires: the time when the emphasis on accumulating assets gives way to the need to withdraw assets.)

An analysis from BlackRock bears this out. The asset manager compares three model investing scenarios: three investors start portfolios with lump sums of $1 million, and each of the three portfolios averages a 7% annual return across 25 years. In two of these scenarios, annual returns vary from -7% to +22%. In the third scenario, the return is simply 7% every year. In all three scenarios, each investor accumulates $5,434,372 after 25 years – because the average annual return is 7% in each case.1

 Here is another way to look at it. The average annual return of your portfolio is dynamic; it changes, year-to-year. You have no idea what the average annual return of your portfolio will be when “it is all said and done,” just like a baseball player has no idea what his lifetime batting average will be four seasons into a 13-year playing career. As you save and invest, the sequence of annual portfolio returns influences your average yearly return, but the deviations from the mean will not impact the portfolio’s final value. It will be what it will be.1

 When you shift from asset accumulation to asset distribution, the story changes. You must try to protect your invested assets against sequence of returns risk.

 This is the risk of your retirement coinciding with a bear market (or something close). Even if your portfolio performs well across the duration of your retirement, a bad year or two at the beginning could heighten concerns about outliving your money. 

For a classic illustration of the damage done by sequence of returns risk, consider the awful 2007-2009 bear market. Picture a couple at the start of 2008 with a $1 million portfolio, held 60% in equities and 40% in fixed-income investments. They arrange to retire at the end of the year. This will prove a costly decision. The bond market (in shorthand, the S&P U.S. Aggregate Bond Index) gains 5.7% in 2008, but the stock market (in shorthand, the S&P 500) dives 37.0%. As a result, their $1 million portfolio declines to $800,800 in just one year.This would leave many at a risk of outliving their retirement funds.

Risk management planning may help balance safety and growth for a more secure retirement. While a market crash early in retirement can have a huge impact, another risk to outliving retirement funds can be forsaking growth altogether while seeking safety.  For a retirement span of 20, 30 or more years, it’s important for the investments to keep up with inflation, taxes and healthcare costs.  The money needs to still be working and growing for retirees.  So what’s the correct balance?

A comprehensive financial plan should include an in-depth risk analysis with investments that align with the results.  It’s important to utilize a financial planner that can utilize advanced software in assessing risk and creating an investment plan that has been stress-tested for an acceptable level of projected success.  These projections can help provide a plan to account for market fluctuations, inflation, rising health-care costs and taxes.

 So, is it time to get off of the proverbial roller-coaster?  If you are about to retire, it may be.  This is where carefully tested planning is crucial.  However, If you are far from retirement, enjoy the ride and keep saving and investing.  The sequence of returns will have its greatest implications as you make your retirement transition.

    

Citations.

1 – blackrock.com/pt/literature/investor-education/sequence-of-returns-one-pager-va-us.pdf [6/18]

2 – kiplinger.com/article/retirement/T047-C032-S014-is-your-retirement-income-in-peril-of-this-risk.html [7/3/18]