Protecting Against “Sequence-of-Return Risk”

If you know me, you will know that one of my all-time favorite mantras is that investing is all about “time in the markets”, NOT “timing the markets”.  The message is: never try to time the markets or bother trying to guess when they will go up or when they will go down.  To put the odds of success on your side, you need to be in for the long haul; if you can’t do that, then you should simply be out. 

However, there is one time in investing when timing means everything, and that is the timing of when you start to systematically take money from your investment portfolio for income needs.  For most of us, this will likely be when we retire.  Once we have stopped earning an income from employment we begin to turn to our investment portfolio to provide the income we will need to get us through.  And this is where timing becomes critical and where “Sequence-of-Return Risk” can play a huge factor.  To be clear, I still don’t suggest trying to time anything here, but timing is, in fact, crucial.  I know that sounds a little bit odd, but let me explain…

If you retire and start taking money systematically from your portfolio, and during the first few years of retirement the markets do well, but then, some years later, they do poorly, you will be in a much better situation than if the bad years had come first.  This is basically what “Sequence-of-Return Risk” means.  When do you get the good years and when do you get the bad years, after you have started to take income from your investment portfolio?  Essentially, what is the sequence of your returns at this critical juncture? Let me give an example of two different investors to help illustrate why the sequence of your portfolio returns is so important during this time.

In our example, we have two investors.  Let’s call them Investor A and Investor B.  Both have $1,000,000 in their portfolios when they start retirement.  Both earn the same annualized return over their 30-year retirements, but Investor A has good, positive investment returns early in retirement, with some bad years coming later on; by contrast, Investor B has bad, negative investing returns early in retirement and good years later on.  Even though investors A and B both start with the same amount invested, and both earn the same annualized return over the long run, they almost certainly end up in very different places from a portfolio-value perspective at the end of the 30-year timeframe. I know it may seem counterintuitive – that they can start with the same amount, get the same annualized rate of return, and still have different results – but as I’ll explain, it’s not only true, but highly likely.

Example #1 – Good Timing Early

Let’s assume Investor A gets lucky, and for the first three years of retirement, her portfolio returns a whopping 15% per year. Then things settle down, and she earns a more normalized 5% for several years, and then in the tenth year, things finally get nasty in the markets, and she gets a negative 15% return each year for years ten, eleven and twelve.  After that, starting in year thirteen and for the remainder of her 30-year retirement, she receives a 5% return each year.  This portfolio would be worth just over $3,000,000 after thirty years.  This amounts to an annualized rate of return of almost 3.75%.

Example #2 – Bad Timing

Now, let’s turn to our unlucky investor, Investor B.  Investor B’s portfolio returns negative 15% per year for the first three years, then does positive 5% for several years, and in the tenth year things get good, and he earns a positive 15% return each year for years ten, eleven and twelve.  After that, as in the first example, starting in year thirteen and for the rest of retirement he receives a 5% return each year.  This portfolio is also worth just over $3,000,000 after thirty years, or, once again, an annualized rate of return of almost 3.75%.

So far all we’ve done in the above examples, is change the timing, or sequence, of the good and bad years.  Investor A got the good years immediately and the bad years starting in year ten.  Investor B got the bad years immediately and the good years starting in year ten.  Everything else remained the same.  The result is that they both earned almost 3.75% per year on an annualized basis, and they both end up with just over $3,000,000.  So far, the sequence of returns, or when the good and bad years occurred, did not make any difference.  The problem here, comes when you start to systematically take money from your portfolio, as most retirees do. This is where “Sequence-of-Return Risk” can rear its ugly head.

Continuing with the above examples, let’s assume the same information as before for both investors A and B, but add in the fact that they are both taking $50,000 per year from their portfolios; we will further assume that this amount increases with an inflation rate of 3% each year.

Now, lucky Investor A, who got the good returns early, and the bad returns a bit later starting in year ten, runs out of money after twenty-two years.  However, unlucky Investor B, who got the bad returns early, and the good returns a bit later starting in year ten, runs out of money after only thirteen years.  So, while mathematically these two investors would have received the exact same rate of return, if no withdrawals had been taken, once withdrawals are accounted for, the investor who had good timing, and retired into a strong bull market has money for an additional nine years (or 70% longer), simply due to timing, or the sequence of returns.  As you can see, the timing, or sequence of returns, makes a huge difference.  Now, the problem here is that no one knows when the good years and the bad years will be, which, of course, is why we don’t try to time the markets.  And even though we can’t predict the markets, what we can do is plan and prepare, using one or more of three basic options for dealing with “Sequence-of-Return Risk.”

The first possible solution to “Sequence-of-Return Risk”, would be to have so much money saved that it doesn’t matter.  If you are very fortunate, it’s possible that you have saved so much money for retirement that it doesn’t matter what sequence of return you achieve: your investment portfolio will still last as long as you are alive.  If you are in this situation, congratulations, you have won the game.  However, for most of us, this is not a realistic solution.

The next strategy, is to have enough money set aside as cash reserves, so that when you begin retirement, you won’t be forced to take money from your portfolio at the wrong time, that is, if markets happen to be down significantly in the first few years.  With this strategy, you set aside somewhere between one and three years worth of your retirement-income needs as cash reserves (three years obviously being ideal).  For example, if you need $50,000 per year from your investment portfolio, you would keep $150,000, or three years’ worth of your income needs, set aside as cash reserves.  If your financial plan shows that you can afford to do this and still have enough invested to meet your financial goals, then you have provided yourself an insurance policy against “Sequence-of-Return Risk.”

In this scenario, if you happen to retire at exactly the wrong time, during a bear market, you won’t have to touch your investment dollars for up to three years.  You can live off your cash reserves during the early years of retirement and give your investment portfolio time to recover from the downturn.  Of course, if the bear market continues for many many years, you will eventually have to access your portfolio during a down market. But three years is a long bear market, and having this cash is a really good insurance policy to help mitigate the risk of bad sequence of returns early in retirement.

The third possible strategy to protect against “Sequence-of-Return Risk”, is to use other non-investment portfolio assets for your income needs during a downturn.  This could be in the form of financial help from friends or family that are in a stronger financial situation and can afford to help without jeopardizing their own chances for success.  However, most people can’t, or do not want to rely on others.  For most people, the only significant asset that is not invested in the stock and bond markets, is their home.

With this third strategy, you may be able to use your home’s value during a market downturn, which is really just another form of insurance against “Sequence-of-Return Risk.”  For most people, this would entail the use of a Home Equity Line of Credit (HELOC), or a reverse mortgage, during these bad early years.  If you happen to retire at the wrong time, and the markets go down significantly in the early years, you would simply access the value of your home for your income needs, leave your investments alone, and wait out the downturn. You could then choose to pay back these loans from your investment portfolio when the markets eventually recover, or, if you’re using a reverse mortgage, you may choose to never pay back the loan unless you decide to leave your home, or until you eventually pass away.  Either way, you have been able to leave your investment portfolio assets invested through the early bad-return years, by relying on other assets during the downturn.  This is another form of insurance against the risk of bad sequence-of-returns early in retirement.

Once again, let me stress the fact that you should never try to time the markets, and you can never predict them for the short-term. However, with proper planning, you can prepare for the worst, so that you are never caught by surprise and are able to put the odds of long-term success more firmly in your favor.


The commentary on this website reflects the personal opinions, viewpoints and analyses of the Topel & DiStasi Wealth Management, LLC employees providing such comments, and should not be regarded as a description of advisory services provided by Topel & DiStasi Wealth Management, LLC or performance returns of any Topel & DiStasi Wealth Management, LLC Investments client. The views reflected in the commentary are subject to change at any time without notice. Nothing on this website constitutes investment advice, performance data or any recommendation that any particular security, portfolio of securities, transaction or investment strategy is suitable for any specific person. Any mention of a particular security and related performance data is not a recommendation to buy or sell that security. Topel & DiStasi Wealth Management, LLC manages its clients’ accounts using a variety of investment techniques and strategies, which are not necessarily discussed in the commentary. Investments in securities involve the risk of loss. Past performance is no guarantee of future results.