How does the Sequence of returns impact my investment value?

This Article contains information from AAII Journal

There are five key risks that can have a significant impact on whether your savings last the full length of your retirement: withdrawal rate, market performance ,inflation, health care costs and longevity.

Let’s look at how market performance – especially the order in which you experience different returns – can affect how long your savings will last. It’s a fact that the order in which you experience positive and negative returns can significantly impacts how your portfolio performs. The big uncertainty is what actual sequence of returns you will experience in the future.

The sequence of positive and negative returns is particularly important during the period surrounding the transition into retirement; when you move from accumulating assets to drawing down your savings.

Without Withdrawal

 This Graph shows the returns for a hypothetical fund in reverse order, indicating that the average returns remain the same regardless of their order. This is showing no withdrawals.

This Graph shows the returns for a hypothetical fund in reverse order, indicating that the average returns remain the same regardless of their order. This is showing no withdrawals.

Wealthplanning AII graph no withdrawal

The portfolio has a starting value of R100,000 allocated to 60% large-cap stocks and 40% bonds performed over the period of 1988 (Year 0) through 2014 (Year 27) using the actual returns of two Vanguard mutual funds and no changes (neither withdrawals or rebalancing) made (“Actual” line). The chart also shows how the same portfolio would have performed if the year with the highest return occurred first and each subsequent year had lower a lower rate of return (“Best to Worst”) as well as if the order were reversed so that the year with the worst return occurred first and each subsequent year had a higher rate of return (“Worst to Best”). The Best to Worst scenario experienced the most upside (nearly R2.5 million) because of compounding and 22 consecutive years of gains. Even though the paths are different, all three scenarios end up in the same place. This is because under hypothetical conditions, as long as no changes are made to the portfolio, the cumulative return is the same. The only thing that is altered is the order, or “sequence,” in which the annual returns occur. If any changes to the portfolio are made at a given point in the time, then two moving parts affect the eventual the outcome: the sequence of returns and the impact of making a change to the portfolio at one or multiple points over the specific period.

With Withdrawals

When withdrawals are being made, two big factors influence whether a portfolio will last a person’s lifetime. The first is the outflow of Rands to support a person’s (or a couple’s) lifestyle. These outflows reduce the portfolio’s size at the time the withdrawal is made. The second is the return on investments. A positive return, particularly one in excess of the withdrawal amount (e.g., 7% of portfolio value) can extend the number of years a portfolio lasts. A negative return can shorten a portfolio’s duration. The Figure below illustrates the same three scenarios—actual sequence, returns received in order of best to worst and returns received in order of worst to best—with retirement withdrawals factored in. A withdrawal rate equal to 4% of the initial portfolio balance, adjusted each year for inflation, is used.

Under the actual returns scenario, the retiree maintained a considerable amount of wealth relative to his or her savings at the start of retirement. The portfolio benefited by having the bad years dispersed throughout the time period.

The best-to-worst scenario was also favorable for the retiree. The biggest gains in the equity markets coincided with the years the withdrawals were the smallest. This allowed the portfolio to take advantage of the big up years and grow considerably. The resulting gains were large enough to carry the portfolio through the big down years late in the scenario. Conversely, the worst-to-best scenario left the retiree with an ending portfolio value of approximately R8,700. Assuming withdrawals would continue to be increased with the rate of inflation, the portfolio would be completely drained in less than two additional years beyond the period used in the scenario.

Two simultaneous events coincided to wreck the portfolio under the worst-to-best scenario. The first is the span of five consecutive years with falling stock prices at the start of the scenario. These drops occurred when the allocation to stocks, in Rand terms, was at its largest. The second was the stream of withdrawals. The retiree increased the withdrawal amount at the same time that the portfolio was experiencing big drops in value. By the time the stock market’s returns reached positive double-digit percentages, the damage to the portfolio was done.

The big keys are to stay disciplined, never panic and realize that even in the worst-case scenario, there may be more than one action that can be taken to lessen the financial damage.