Sequence of Returns Risk

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DonCamillo
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Sequence of Returns Risk

Post by DonCamillo »

We tend to use the word “risk” loosely on the Boglehead forum, primarily because we are exposed to so many risks in investing. For example, Investopedia http://www.investopedia.com/exam-guide/ ... -risks.asp mentions Interest Rate Risk, Business Risk, Credit Risk, Taxability Risk, Call Risk, Inflationary Risk, Liquidity Risk, Market Risk, Reinvestment Risk, Social / Political / Legislative Risk, and Currency / Exchange Risk. That is only a single list, and is not comprehensive.

Project managers take a disciplined approach to risk. When they develop a project plan, they ask, “What can go wrong?” This is potential problem analysis. After analysis determines the potential problems, they are classified according to probability and severity. Risk events that are likely to occur and will have moderate to severe impacts on the project are then analyzed. This results in one of three actions; change the project plan to avoid the risk, accept the risk, or develop a risk mitigation plan to use if the risk event occurs.

You have to be concerned about different risks at different times in your investing history. A risk that does not affect the accumulation phase, but can be very important shortly after retiring, is the Sequence of Returns Risk. Suppose that you save $1 million for retirement, expecting to withdraw 4%, or $40,000 a year, to live on. What happens if the stock market drops 50% shortly after you retire? You now have only half a million dollars, and 4% will only provide you with $20,000 a year.

How can you deal with this risk? You can deal with a risk by avoiding it.

Upon retiring, you use your savings to buy an annuity. You have now avoided the sequence of returns risk, although you have exposed yourself to other risks, such as inflation risk.

You can avoid sequence of returns risk by investing your retirement funds in a bond ladder, or minimize it by investing in bond funds.

Another way to deal with sequence of returns risk is by mitigating it.

Sequence of returns risk is one of the risks that can be mitigated by diversification. In the original example, instead of having all your investments in equities, you had half in equities and half in bonds, then your portfolio would likely drop only 25%, and you would still be able to spend $30,000 a year. viewtopic.php?f=10&t=157730&p=2387164&h ... s#p2387164

Formally, a mitigation plan is one that comes into effect when the risk event occurs. Taylor Larimore has advocated a popular risk mitigation plan for sequence of returns risk on Bogleheads; when you have poor returns, spend less. “You can live the way you must” viewtopic.php?f=10&t=45847&p=595816&hil ... re#p595816

I have been trying to develop my own risk mitigation plan for sequence of returns risk. The plan is to depend on pensions as the primary source of basic living expenses. If pensions are insufficient, annuitize enough of my tax deferred investments to cover the basic expenses. After that, use only dividends and interest for discretionary expenses, and save the principal in my investments for medical bills, long term care expenses, and bequests, all of which tend to occur near the end of retirement.

I noticed during the 2008 stock market turmoil that while some dividends, especially financials, were lowered or suspended, most other dividends continued. Therefore, this strategy should have a higher success rate than depending on a safe withdrawal rate.

My strategy also has two components that will be helped by lower stock market values. First, I am subject to required minimum distributions. Since I accomplish these by simply moving some of my Vanguard Total Stock Market Index Fund from an IRA to a taxable account, lower market value just means that I pay fewer taxes on the transfer. Second, I am moving bonds from an IRA to a Roth, largely as a way to control the growth of minimum required distributions. Here again, a lower value means that I can transfer more for the same tax cost. In both cases, I am assuming that the lower market values will recover over time, but in the future, the equity will be capital gains, not ordinary income, and any growth on the bonds will be tax free.
Les vieillards aiment à donner de bons préceptes, pour se consoler de n'être plus en état de donner de mauvais exemples. | (François, duc de La Rochefoucauld, maxim 93)
longinvest
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Re: Sequence of Returns Risk

Post by longinvest »

I invite you to put "VPW" in the search box and learn about previous work on this subject.
Variable Percentage Withdrawal (bogleheads.org/wiki/VPW) | One-Fund Portfolio (bogleheads.org/forum/viewtopic.php?t=287967)
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Bustoff
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Re: Sequence of Returns Risk

Post by Bustoff »

longinvest wrote:I invite you to put "VPW" in the search box and learn about previous work on this subject.
Your contribution on this is amazing. I wish I understood how to work it. You obviously put an enormous effort into it.
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nedsaid
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Re: Sequence of Returns Risk

Post by nedsaid »

The sequence of returns risk is a difficult problem for recent retirees and near retirees to fix.

Prudential insurance has introduced an excellent concept called the "Retirement Red Zone." The idea is that investors are most vulnerable to bear markets between the five years or so before retirement and the five years or so after retirement. A bear market during this time period can be just devastating to a retiree, putting him or her in a hole that one might never climb out of. I love the concept but do not endorse the annuity they are selling to solve the problem.

I suppose I will do a number of things to deal with this issue.

First, I would annuitize a portion of my retirement portfolio. Second, put several years worth of withdrawals into short term bond funds, a variation of the Ray Lucia buckets strategy. Third, maintain my portfolio of individual dividend paying stocks which is about 15% of my portfolio. Fourth, considering portfolio insurance that would include such things as gold, commodities, natural resource funds. Portfolio insurance might be a small drag on my returns but would be there to guard against unusual events. Fifth would be reducing my stake in stocks which right now is about 70% of my portfolio.

So these are things I have thought over though my thinking has not been fully formed on this topic. I am still thinking of ways to deal with this problem.
A fool and his money are good for business.
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DonCamillo
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Re: Sequence of Returns Risk

Post by DonCamillo »

longinvest wrote:I invite you to put "VPW" in the search box and learn about previous work on this subject.
Your Variable Percentage Withdrawal Strategy is certainly attractive. It looks like a very workable approach to the sequence of returns risk, and at 536 posts, is certainly well discussed.

I do have a family bias toward "never dip into capital," and adequate savings, so I think I still prefer to spend only income. But VPW looks like a good alternative to partial annuitizing if I want to increase my standard of living. Thanks for the link.
Les vieillards aiment à donner de bons préceptes, pour se consoler de n'être plus en état de donner de mauvais exemples. | (François, duc de La Rochefoucauld, maxim 93)
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ogd
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Re: Sequence of Returns Risk

Post by ogd »

DonCamillo wrote:I noticed during the 2008 stock market turmoil that while some dividends, especially financials, were lowered or suspended, most other dividends continued. Therefore, this strategy should have a higher success rate than depending on a safe withdrawal rate.
Actually this didn't really happen or it would have been visible on total return charts. Which, to my knowledge, it isn't.

The reason is simple if counterintuitive (it took me a few posts on this very forum to figure it out): total return is with dividends reinvested. Every dividend withdrawn means a few shares not bought at those low prices, compared to that total return chart. Which is no more, no less damaging than the same amount of shares sold.

Try this challenge if you're not convinced: come up with a scenario where spending the dividends of stock A leads to a better outcome than selling shares of the dividend-less stock B, yet the total return of the two stocks is the same over any part of the period. You can't.

So it follows that if a certain class of stocks were better at supporting withdrawals during the crash, their total return must have been higher. This, unlike withdrawal scenarios with their many parameters, is easily verified and probably false unless you maneuver your way around the stocks that you know did worse than others. Which going forward you can't have any guarantees of.

The same rationale actually applies to bond ladders, but it's a somewhat longer discussion. The gist of it is, both coupon and maturing bonds that you don't reinvest cost you the same going forward (specifically, the market yields at that point, whether higher or lower than now) as sales from a bond fund. I say it's complicated because we'd probably get into a discussion of how you'll taper your bonds and how this changes your risk over time which is harder to do with a fund, but any time you compare apples to apples by duration (and quality, I suppose) you'll get the same answer.

As I see it, risk is intrinsic to the asset types I buy and any strategy of shifting between distributions and capital, or enforcing a certain shape of distributions, does nothing to avoid or reduce that risk. I only reduce it when I shift between asset types, or take money off the table entirely.
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DonCamillo
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Re: Sequence of Returns Risk

Post by DonCamillo »

ogd wrote:
DonCamillo wrote:I noticed during the 2008 stock market turmoil that while some dividends, especially financials, were lowered or suspended, most other dividends continued. Therefore, this strategy should have a higher success rate than depending on a safe withdrawal rate.
Actually this didn't really happen or it would have been visible on total return charts. Which, to my knowledge, it isn't.

The reason is simple if counterintuitive (it took me a few posts on this very forum to figure it out): total return is with dividends reinvested. Every dividend withdrawn means a few shares not bought at those low prices, compared to that total return chart. Which is no more, no less damaging than the same amount of shares sold.

Try this challenge if you're not convinced: come up with a scenario where spending the dividends of stock A leads to a better outcome than selling shares of the dividend-less stock B, yet the total return of the two stocks is the same over any part of the period. You can't.

So it follows that if a certain class of stocks were better at supporting withdrawals during the crash, their total return must have been higher. This, unlike withdrawal scenarios with their many parameters, is easily verified and probably false unless you maneuver your way around the stocks that you know did worse than others. Which going forward you can't have any guarantees of.
I will concede the point. In 2008, I had not yet discovered Bogleheads, and was following a Dividend Growth strategy. Therefore, my attention was on my dividend income, not total return.

This in turn means that my strategy is not optimized for total return, as spending income is equivalent to any other form of withdrawal. "Never touch capital" has an element of fantasy to it. There is no such thing as a free lunch.
Les vieillards aiment à donner de bons préceptes, pour se consoler de n'être plus en état de donner de mauvais exemples. | (François, duc de La Rochefoucauld, maxim 93)
Leeraar
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Re: Sequence of Returns Risk

Post by Leeraar »

Sequence of Returns is real, if under-appreciated. Let's say you're investing over a period of 20 years, and getting a nominal return of 4%.

If you invest a lump sum amount, the sequence of returns does not matter.

If you are saving, lower returns towards the end of the period can have a huge negative effect, even though the nominal annual rate is still 4%.

If you are withdrawing, lower returns towards the beginning of the period can have a huge negative effect, even though the nominal annual rate is still 4%.

Put the latter two together and yes, there is a "Retirement Red Zone". That is why Pfau and others point out that lowering your allocation to equities as you transition to retirement may be advisable.

We are working on a Wiki entry on the topic, and will certainly mine threads like this for information.

L.
You can get what you want, or you can just get old. (Billy Joel, "Vienna")
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nedsaid
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Re: Sequence of Returns Risk

Post by nedsaid »

Leerar, when you have finished the Wiki entry on the sequence of returns issue, could you start up a thread and let us know. This is an issue that all of us will need to address at some point.
A fool and his money are good for business.
Leeraar
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Re: Sequence of Returns Risk

Post by Leeraar »

nedsaid wrote:Leerar, when you have finished the Wiki entry on the sequence of returns issue, could you start up a thread and let us know. This is an issue that all of us will need to address at some point.
Absolutely. There are at least three ways this is done:

1. A Forum thread when a new topic is under discussion or posted in the Wiki.

2. On each Wiki page there is a tab to make suggestions on how the entry can be improved.

3. Become a Wiki editor, and change the page yourself.

Also, if you look at the Wiki page history, you can see who the editors are. Caution: I am not sure that the Wiki editor user names are always the same as the discussion Forum user names.

Building the Wiki is fun, except you must realize that making a suggestion usually means you just volunteered!

L.
You can get what you want, or you can just get old. (Billy Joel, "Vienna")
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