One often overlooked risk in investing is "Sequence of Return Risk". That is the idea that two investors that are periodically adding or withdrawing funds from their portfolio can experience the exact same average returns but end up with vastly different results.
To help illustrate, let's first look at two hypothetical investors that invest $100,000 but never add or withdraw any funds from their account. Investor A starts investing in 2000 and we track him for 15 years through the end of 2014. Investor A's returns mirror those of the S&P 500* during that time-frame. Then we have Investor B. Investor B experiences the same annual returns as Investor A but in REVERSE ORDER.
As you can see, despite the change in the order of their returns....their end results were exactly the same! This would be the case regardless of which order the returns came. So why was I talking about "Sequence of Return Risk? Well, in the real world, portfolios experience contributions and withdrawals and it matters in both scenarios.
To illustrate, let's look at the same two investors but assume they are in their retirement phase and need to take $5,000 at the end of each year from their accounts. What do the results look like then?
In this case, Investor A ended the 15 year period with dramatically less money. This is sequence of return risk. Investor A experienced poor returns early on when he started withdrawing funds from his account and as a result there was less money to compound at the higher rates towards the end of his 15 year period.
This is why it is important to reduce the volatility of a portfolio during the withdrawal phase in retirement. While this is more widely understood during the withdrawal phase, many people overlook it's equal importance as investors add money to their account during the accumulation (contribution) phase.
We will look at Investor A and Investor B once again, however, this time we will assume that they have just started adding to their portfolio. In this case, they both start with $5,000 and then add $5,000 at the end of every year.
In contrast to the last example, the sequence of returns for Investor A actually worked to their advantage in the accumulation phase. This is because the account value was smaller when it experienced the majority of losses, and they had accumulated a larger balance towards the end which benefited from the positive years.
Therefore, despite both investor experiencing the same returns and both investors contributing a total of $80,000 (initial value of $5,000 plus $75,000 in contributions), they ended with much different results.
Sequence of return is a real risk and highlights the importance of not only reduced volatility in the withdrawal phase of retirement, but also its importance in the later part of the accumulation phase when the balance has grown and there will be less years to "buy low".
For more on Sequence of return risk during the accumulation phase I highly recommend a white paper by GMO entitled "Who Ate Joe's Retirement Money".
Adam Jordan, CIMA®, AAMS®
Director of Investment Research & Management
*The S&P 500 is an unmanaged group of securities considered to be representative of the stock market in general. You cannot invest directly in an index. Past performance does not guarantee future results. Opinions expressed are not intended as investment advice or to predict future performance.
These examples are hypothetical only, and do not represent the actual performance of any particular investments. Investments in securities do not offer a fixed rate of return. Principal, yield and/or share price will fluctuate with changes in market conditions and when sold or redeemed, you may receive more or less than originally invested.