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Sequence of Returns: More than Meets the Eye

Even well-informed investors sometimes overlook the fact that the timing and frequency of their contributions and/or distributions from their investment accounts can have a substantial impact on their overall portfolio. In investment and financial planning terminology, this is referred to as “sequence of returns risk.”
More than Meets the Eye title image

A few years back I was deeply engaged in one of my favorite hobbies, mowing my lawn while listening to investment podcasts, when I had an epiphany about how I might be able to illustrate this tough to understand concept. If you are already lost, bear with me, the following thought experiment should help.

Suppose it is 2007 and you are planning to retire at the end of the year. You’ve done some financial planning and you know that you’ll need to withdraw $55,000 from your $1,000,000 retirement account for the next 10 years. Somehow, you’ve obtained the investment equivalent to Biff’s Almanac from Back to the Future and know with complete certainty what the average return of two different investment portfolios will be over that 10-year time horizon. Portfolio A will produce an average return of 7.71% and Portfolio B will produce an average return of 5.61%. Which portfolio leaves you with the most money at the end of the 10 years?

Table: Sequence of returns 1

When I talk through this with people, I reveal that Portfolio A is Berkshire Hathaway and that Portfolio B is a 60% stock, 40% bond portfolio that Baker Boyer utilizes. That further drives people to assume that of course the answer is Portfolio A, but they end up being wrong as the table below shows.

Table: Sequence of Returns 2This is the point where people begin scratching their heads wondering how in the world the math can work out that way. This is due to a concept known as sequence of returns risk. In a nutshell, when the volatility of an account increases, people withdrawing from their accounts are forced to sell more shares of their investments to meet their living expenses. Managing the volatility of an investment portfolio is incredibly important depending on the person’s financial plan. To illustrate this further, what if we reversed the situation and said that rather than withdrawing, you were contributing $55,000.

Table: Sequence of Returns 3

Granted, to get these results I had to get specific about taxes, withdrawal and contribution amounts, and time periods to get the results I wanted. But, I think it highlights the fact that the right portfolio is dependent on each individual situation.

When applying this concept to clients’ investment portfolios, most clients should have a larger percentage of stocks when they are contributing with a gradually increasing allocation to bonds as they reach their retirement age. For roughly the five years preceding retirement and the first five years of retirement, that client should err toward a more conservative portfolio. The goal in that time period is to reduce the volatility in the portfolio so that they don’t become forced sellers as shown in the first example above. It’s counterintuitive for most to realize that a lower annualized return can result in more wealth over a given time period.

A key takeaway from this is that the right portfolio is one that takes your personal financial plan into account. Things like taxes, savings rates, social security, and pensions can all influence the portfolio construction process.

So, the next time you ask yourself “What’s the right portfolio for me?” slow down and think through your entire financial situation. In my next article, I’ll dive a little deeper into a question that nearly every client has, “How much can I spend in retirement?”

About the Author

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Brian K Bruggeman, CFP®, CTFA
Executive Vice President
Chief Innovation Officer
Director of Financial Planning
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