A simply complex, but vital contributor to the success of your retirement plans are the sequence of your investment returns. Many investors assume that a given sample of returns will yield the same outcome, and they would be correct, in a world with infinite liquidity. But in the real world, when the money is gone, the game is over.
The Power Hidden in Order:
In the realm of finance, the sequence of returns refers to the order in which investment gains or losses occur over time. For retirement planning, it becomes a crucial factor, as the order of positive and negative returns can significantly impact the overall value of a portfolio.
Let's introduce two fictional retirees:
Financial math can almost seem like a trick at times. A 10% gain and a 10% loss does not actually equal “break-even”. If you have $100,000 and earn 10%, you now have $110,000. But if you lose 10% of $110,000 ($11,000), you now have only $99,000, 1% less than your starting point. Run this math backwards, losing 10% before regaining it, and you will find the same outcome. This effect is amplified the greater the magnitude of gains and losses experienced.
The Impact of Timing:
An interesting wrinkle to this is the effect of the sequence of the returns on the outcome for investors who take regular withdrawals from their account. To illustrate this effect, let’s consider a recent example: For all intents and purposes, the 5-year period lasting from 2018 – 2022 was a pretty “typical” list of returns for the S&P 500 overall.
Year | S&P 500 Return |
2022 | -18.04% |
2021 | 28.50% |
2020 | 18.06% |
2019 | 31.20% |
2018 | -4.23% |
Fast forwarding through some math, if you invested $1 million in the S&P 500 index on 12/31/2017 and withdrew $50,000 from your account on the 12/31/18 and every New Year’s Eve thereafter, by the end of last year, your account balance would have been $1.275 million.
But let’s play a game of what if: Re-arrange the exact same annual returns in ascending order, beginning with a -18.04% return in 2018 and ending with a 31.20% return in 2022, and the final balance changes significantly.
Year | Return | Balance |
1 | -18.04% | $ 769,600 |
2 | -4.23% | $ 687,046 |
3 | 18.06% | $ 761,126 |
4 | 28.50% | $ 928,047 |
5 | 31.20% | $ 1,167,598 |
As you can see, the ending balance is now just $1.17 million, 8% less than the original result, or about 1.75% less per year over the 5-year average.
If you flip the numbers around yet again, experiencing the best returns first, and you see the opposite:
Year | Return | Balance |
1 | 31.20% | $ 1,262,000 |
2 | 28.50% | $ 1,571,670 |
3 | 18.06% | $ 1,805,514 |
4 | -4.23% | $ 1,679,140 |
5 | -18.04% | $ 1,326,223 |
Your final balance in this scenario is 4% higher than the opposite order of returns 13.6% higher, or 2.5% per year on average.
Moral of the story?
Don’t lose money early in your retirement. Well, sure. But for that matter, it would be sound advice to never lose money at all, if that were within our control. However, the example should offer a valuable lesson on the importance of managing risk, especially early in your retirement years as you start relying on your assets to cover your living expenses.
If you are unsure if your current investments are the proper fit for your overall retirement plan, please schedule a free consultation and I would love to learn more about how I can improve your long-term strategy.