User:Leeraar/Sequence of return risk

Sequence of return risk is an important concept for those in the early years of their retirement and also for those who are saving in the accumulation phase.

Sequence of return
Investing examples often assume that investment returns are constant, year to year. Of course that is not the case (see Fig.1).

If a market drop occurs early in one’s retirement, when withdrawals are being taken from savings, there can be a dramatic effect on the sustainability of the portfolio. In fact, the retiree may run out of money a decade or more sooner than if the market delivers a constant return. Bernstein, Otar, and Zwecher all discuss this issue. Recent publications by Pfau, Kitces, and others also explain the issue.

The following example is a hypothetical illustration and does not represent the return on any particular investment. It is intended to illustrate the basic effect. Suppose an investment returns 4% over a decade, but, in one of those years, it drops 30%. (So, in the other nine years it returns 8.68%, for an APR, annual percentage return, of 4%.) Let’s consider what happens if the 30% loss occurs in the second year, or in the ninth year.

Case 1: Making withdrawals (Retired) Suppose an investor starts with $10,000, and intends to withdraw $1,000 per year. If the 30% loss occurs in year two, the ending balance is $116. If the loss occurs in year nine, the ending balance is $3,945.

Case 2: Accumulating (Making investments) Suppose an investor starts with zero, but saves $1,000 per year for ten years. If the 30% loss occurs in the second year, the ending balance is $14,690. If the loss occurs in the ninth year, the ending balance is $10,861.

Case 3: Lump sum invested Suppose an investor starts with $10,000 invested and makes no investments or withdrawals for a decade. In this case, the end balance is $14,806, and the sequence of returns does not matter.

So, for a given long-term APR, If you have a lump sum invested, the sequence of returns does not matter. If you are a periodic investor, a better result will be obtained if lower returns occur earlier rather than later. If you are making withdrawals, a worse result will be obtained if lower returns occur earlier rather than later.

Illustrated example
In the chart below, two hypothetical portfolios, A and B, each begin with $100,000. Each investor aims to withdraw $5,000 per year, and it is assumed that both portfolios experience exactly the same compound annual returns over a 25-year period, only in inverse order, or “sequence.” Portfolio A has the bad luck of having a sequence of negative returns in its early years and is completely depleted by year 20. Portfolio B, in contrast, scores a few positive returns in its early years and ends up 25 years later with more than double the amount of assets it started with.