Sequence of Returns Risk: Why Diversification & Reducing Volatility Matters

Having a good average return is not necessarily good enough – just ask someone who retired 25 years ago.

Last year was a good year for the U.S. stock market, with the S&P 500 up over 23% in 2023. Go back twenty-five years, which would be 1999, investors also enjoyed a good year in the market – the S&P 500 was up over 19% that year. In the 25 years starting 1999 and ending in 2023, the S&P 500 was up in 18 of the 25 years and produced an average annual return of 7.18%. Fairly good returns considering this period included the dot-com bubble burst, the 9/11 terrorist attacks, America’s longest war, the Great Financial Crisis, the COVID-19 pandemic, presidential impeachments, major tax law changes in 2003 and 2017 and all sorts of other major social, economic, and geopolitical events. However, despite a good average return, the order of the returns over these 25 years had a major impact on how portfolios performed, especially for investors in retirement who rely on their portfolio to cover their spending needs. Let’s take a deeper dive into an often-misunderstood risk – the sequence of returns risk.

The Order of Returns Matter

Many investors believe as long as they can average 7% returns and only spend about 4% of their portfolio, they can never deplete their assets. However, there are negative years, and your expenses cannot always be reduced. In retirement you may have fixed expenses, and if you rely on your portfolio to cover your retirement spending, you will have to take withdrawals regardless of whether your portfolio is up or down. Let’s start with a basic (albeit extreme) example to refresh our math skills.

Assume you have $100, and you also need to spend $20. You invest the $100 but the economy goes into a deep recession and the market declines 50%, thus you now have $50 in assets. In this scenario you will need the market to bounce back 100% just to breakeven. That is just how the math works: $50 at a 100% return leads to $100. So, a 50% decline requires a 100% subsequent return just to breakeven. However, you are in retirement, and you have to pay your taxes, insurance, medical bills, travel, and eat food and buy gas, and all the other things you need to spend on in retirement. So, you had to spend $20. If the market lost you $50, and you had to spend $20, you now only have $30 left. Just to breakeven and get back to your $100 starting wealth you need to gain $70 back, which is a huge return. You will need a 233% return on your $30 remaining. See the summary below:

This is an extreme example, but it highlights the basic math of how a large negative return, especially coupled with spending, can impact your portfolio during retirement. If you are spending 20% of your wealth every year you will likely have a spending problem and financial planning is going to be difficult. Also, 50% declines, while possible, are not common, especially if you have a well-diversified portfolio. So, the above numbers do not provide a good example of the sequence of returns risk in the real world – let’s look at something more realistic and over a longer time horizon.

Assume you are retiring now, and you expect a 25-year lifespan. You expect an average 7% annualized return will be sufficient to grow your assets and cover your necessary expenses. You expect to spend $200,000 a year, and you have a $5 million investment portfolio. We will ignore all other sources of income – just assume this portfolio needs to cover $200,000 of withdrawals each year. This seems reasonable since that is 4% of the total portfolio size of $5 million. Of course, inflation is real, so we will also have to assume the $200,000 of expenses will grow at 3% inflation. Thus, in year 2 you will need to spend $206,000 to cover the same expenses. To summarize: you have a $5 million portfolio, you will earn an average annualized return of 7%, you will spend $200,000 a year, with 3% average inflation. The main risk you face is how much volatility your portfolio will have, and more importantly, in what order will you experience that volatility and the sequence of the annual returns that average out to 7%. Let’s look at the table below.

What a difference the sequence of returns can make! In one example we assume the portfolio had a straight-line 7% annualized return with no volatility. There were no down markets, no big up rallies, just a steady 7% every year and it works great. Your $5 million portfolio turns into over $9.3 million, and you cover all your expenses along the way. However, we know this is not how investing works in the real world. While markets tend to rise over the long term, there is risk and volatility. Markets go up and down, sometimes significantly over short periods. The second set of returns (the column titled, “Volatility: Sequence of Returns Risk”) has the exact same annualized average of 7%. However, the order of the returns with volatility has a significant impact on your ending wealth – in fact, the money is fully depleted in year 22. Once you have zero assets, the future growth doesn’t matter. Thus, we can ignore the negative numbers in years 22-25, when you lose it all, it is gone, and you have no assets that can recover as markets rebound. These returns are not even that bad. In fact, there were only 5 negative years, the other 20 years were all positive, and again, they averaged a positive 7%, annualized.

This clearly shows the sequence of returns risk – especially for retirees or anyone spending down assets. Large negative returns early in retirement have a greater impact than later in retirement. If you are saving and adding money into the portfolio, volatility is less of a concern, since market declines are an opportunity to invest at better valuations. However, in retirement when you are withdrawing from the portfolio, the volatility, and especially the sequence of returns, is a major risk. This is often why it is prudent to shift into a more conservative, lower-risk portfolio when you retire. Managing volatility and being diversified becomes more important because if you are spending from your portfolio, you have less opportunity and time for your assets to recover from a major decline.

This is not just a hypothetical risk studied by advisors and academics – this order of returns can (and does) happen in the real world. In fact, let’s look back at someone who retired 25 years ago and the actual sequence of returns of everyone’s favorite benchmark – the S&P 500 Index.

Table 2 presents the same facts, with even a slightly better average annual return of 7.18%. However, as you can see, the S&P 500 Index produced a 25-year sequence of returns which could lead to a negative outcome. It even started out great, with almost a 20% up year in 1999, then some down years. In the middle, the Great Financial Crisis, followed by a prolonged stretch of positive years, more recently the markets faced the COVID-19 pandemic and a challenging 2022 as inflation spiked. It ends with a great return in 2023, up over 23%. Overall, a good 7.18% average annual return. However, the last 25 years produced a difficult sequence of returns for retirees.

Many investors mistakenly believe a portfolio of U.S. large-cap stocks is diversified enough. The S&P 500 Index is made up of the largest 500 companies in the United States, operating in all different industries and segments of the market. While the companies are headquartered in the U.S., most have substantial global footprints with operations, supply chains, and customers around the globe (some even have operations in outer space). It is seemingly a truly diversified basket of stocks. However, when you look under the hood, it is not a particularly good index and not truly diversified. (You can read our prior post, Benchmark Envy in Highly Concentrated Markets,which discusses why the S&P 500 Index is not a good benchmark). The main point here is that the order of investment returns matters, and as we can see, the real world can produce extended periods with a bad sequence of returns. So, what do you do about it?

Planning for Sequence of Returns Risk

There are all kinds of risks when it comes to investing. The sequence of returns is just one risk of many you should plan for. The good news is that you do not need to predict the future to be successful, you just need to plan for the uncertain future ahead. No one knows if they will experience large negative returns early in retirement or late. This is also somewhat arbitrary based on the economic cycle at the time you retire. You should certainly expect some negative years – that happens, but you will never know which ones or how negative they might be. Like any investment risk, you must plan ahead and try to build a portfolio and execute an investment strategy that will perform well throughout all the ups and downs of the market. It’s not about “beating” the market or any specific index, it’s about successfully reaching your goals and ensuring you can cover you expenses and live a fulfilling life. The most optimal way to plan for the sequence of returns risk is to have a substantially diversified portfolio and a comprehensive financial planning strategy that addresses and integrates all your planning together, not in isolation.

Asset classes tend to move in cycles, so building a diversified portfolio will help smooth returns and avoid large negative years. Even a diversified portfolio will have declines, but if you can avoid the big drops, you can improve your long-term outcomes. Also, true diversification is more than just stocks and bonds. Within stocks and bonds, you should have additional layers of diversification based on size, style, and geography. Investors should also have a comprehensive planning strategy that focuses on the things within their control, like strategic tax planning, minimizing fees and expenses, diversification, asset location, rebalancing to manage long-term risk, and cash flow modeling to understand appropriate savings and withdrawal strategies before and during retirement.

Cash flow modeling should incorporate Monte Carlo analysis, which is a means to run multiple underlying scenarios to stress test the sequence of returns risk and provide a range of possible outcomes with a statistical probability of success. As you saw in Tables 1 and 2, just assuming a straight-line average return is not realistic and can provide a false sense of comfort – as the saying goes for any model: “garbage in, garbage out”. Using more sophisticated Monte Carlo cash flow modeling is much more helpful for retirement planning and understanding how risk and returns may impact your overall financial outcomes.

No one can control (or predict) if the market will be up or down, so forecasting and predicting is a fool’s game. Focus on your long-term planning, with a comprehensive and diversified strategy. You should monitor and review this strategy over time. Ideally you will work with a comprehensive financial advisor who will help along the way. Good financial planning is not a product or a service, we really view it as a long-term relationship focused on helping our clients throughout their life, investing through various market cycles, planning around tax law changes, and of course their personal or family circumstances may change over time. Also, retirement is not a point-in-time, it is a stage of life, and it often involves some of the most important financial and tax decisions you will ever make. So, planning for retirement is not a one-time event, it is a dynamic process that evolves, often lasting decades. And now you know, the sequence of returns over those decades will have a material impact on your outcomes – start planning for it now.

Sources:

• All returns data from: https://www.macrotrends.net/2526/sp-500-historical-annual-returns

• Average returns calculated in excel based on the data.