Learn to navigate the sequence of returns


Anthony Engrassia


Business Columnist

Monday, September 17, 2018

What exactly is the “sequence of returns?

The phrase simply describes the yearly variation in an investment portfolio’s rate of return. Across 20 or 30 years of saving and investing for the future, what kind of impact do these deviations from the average return have on a portfolio’s final value?

The answer: No impact at all.

Once an investor retires, however, these ups and downs can have a major effect on portfolio value — and retirement income.

During the accumulation phase, the sequence of returns is ultimately inconsequential. Yearly returns may vary greatly or minimally — in the end, the variance from the mean hardly matters.

Think of “the end” as the moment the investor retires: The time when the emphasis on accumulating assets gives way to the need to withdraw assets.)

An analysis from Blackock bears this out. The asset manager compares three model investing scenarios: Three investors start portfolios with lump sums of $1 million, and each of the three portfolios averages a 7 percent annual return across 25 years. In two of these scenarios, annual returns vary from -7 percent to +22 percent. In the third scenario, the return is simply 7 percent every year. In all three scenarios, each investor accumulates $5,434,372 after 25 years – because the average annual return is 7 percent in each case.

When you shift from asset accumulation to asset distribution, the story changes. You must try to protect your invested assets against sequence of returns risk.

This is the risk of your retirement coinciding with a bear market, or something close. Even if your portfolio performs well across the duration of your retirement, a bad year or two at the beginning could heighten concerns about outliving your money.

For a classic illustration of the damage done by sequence of returns risk, consider the awful 2007-09 bear market. Picture a couple at the start of 2008 with a $1 million portfolio, held 60 percent in equities and 40 percent in fixed-income investments. They arrange to retire at the end of the year. This will prove a costly decision. The bond market — in shorthand, the S&P U.S. Aggregate Bond Index — gains 5.7 percent in 2008, but the stock market — shorthand, the S&P 500 — dives 37 percent. As a result, their $1 million portfolio declines to $800,800 in just one year.

If you are about to retire, do not dismiss this risk. If you are far from retirement, keep saving and investing knowing that the sequence of returns will have its greatest implications as you make your retirement transition.

Anthony Engrassia is an investment adviser representative of Mutual of Omaha Investor Services.