Most people know little or nothing about sequence of returns risk. The subject doesn’t make for the most interesting topic for cocktail party discussions. Some refer to it as your biggest retirement risk. Reason being, sequence of returns risk can have a major impact on how long your hard-earned savings will last through retirement. This week's episode we dive in to examples of how you could be affected and steps you could use to fight against it.

Dollar-weighted returns vs time-weighted returns

Many people aren’t familiar with the difference between dollar-weighted returns and time-weighted returns. Dollar-weighted returns are the actual returns you get. The dollar-weighted return is a more accurate representation of your actual return. A time-weighted return impacts your cash flow. A time-weighted return assumes you don’t contribute or withdraw any money during a period of time. If you put a lot of money in the bottom of the stock market and pull the money out at the top of the stock market then you will have a better dollar rated return than a time-weighted return. 

An example of sequence of returns risk

Let’s consider a couple that is 60 years old with a million dollars who just retired. In the first example, they earn 8% each year over the next 30 years. They withdraw at 6% which leads them to the ideal scenario and after 30 years in which they end at zero dollars. Their money ran out just as they did. The second example takes the same couple but rather than earning 8% each year they had great returns of 25% for the first 2 years, then they averaged 8% and then the last 2 years they averaged 0%. This scenario left the couple with a million dollars at the end of 30 years. The last scenario has the couple experience a bad market the first few years then 8% returns and then a great market at the end. This scenario leads the couple to run out of money. Although all of these examples had the same average return the end results were completely different. The first few years have a big impact on your long term success. 

Why did Chad and Mike end up with different balances at the end of their careers?

Chad and Mike work for the same amount of years, they make the same pay and save the same amount each year. One of them begins their career before the other and they retire at different times. The last years before retirement Mike experienced poor returns. Chad had poor returns when he was just starting out. This is an example of a good sequence of returns for Chad and a bad sequence of returns for Mike. The difference ended up being a $300,000 difference between Chad and Mike’s final balance. When you are younger your balance isn’t that big so how the market performs doesn’t matter as much. When you are older it is important to your balance sheet that the market rate of returns are high.

What strategies can you implement to protect yourself from the sequence of returns risk?

1. Diversification is important. Think about a globally diversified portfolio. U.S. stocks, international stocks, large and small cap investments. 
2. Consider your asset allocation. The time right before and right after you retire is not a time to take on a lot of stock risk.
3. Adjust your spending based on portfolio performance.
4. Adjust the amount of stock you own based on market valuations. If the market is expensive you should own less in stocks, if the market is cheap you can own more.
5. Don’t get nervous and go to cash and bonds. Stocks are a good hedge against rising costs of inflation. Remember that people are living longer, you may need that money to stretch farther than you thought.

Outline of This Episode

• [4:27] What constitutes good or bad returns?
• [8:56] The first few years have a big impact on your long term success
• [11:15] Why did Chad and Mike end up with different balances at the end of their careers?
• [14:23] What strategies can you implement to protect yourself from the sequence of returns risk?

Connect With Chad and Mike

• https://www.financialsymmetry.com/podcast-archive/
• Connect on Twitter @csmithraleigh@TeamFSINC
• Follow Financial Symmetry on Facebook

Subscribe To This Podcast

Apple Podcasts Stitcher Google Play