Protecting Your Money from Sequence of Return Risk

| April 14, 2015

Mike's Blog

Knowledgeable investors are aware that investing in the market presents a number of risks. There’s interest rate risk, company risk, market risk, and even purchasing power risk.

Risk is just part of investing. Some types of investment risk, like specific company risk, can be reduced through diversification, another term for not putting all your eggs in one basket.

Risk can also be reduced through a tactical approach: managing your money where you use an exit strategy based on good research to get out of the stock market if the risk gets too high. This is our favorite approach.

As an investor, you face another lesser known risk that cannot be as easily reduced through just diversification, especially if you've been taught to stay in the market all the time. This is a risk of investing your money at the wrong time resulting in the depletion of your assets.

We call this the sequence of return risk. It refers to the unpredictability of the order of returns an investor will receive over an extended period of time.

For example, the stock market, as measured by the S&P 500, has averaged about 10% per year over the last 100 years. It’s normal to think the market will deliver this historical average return over the long- term.

However, you can never know when you will be receiving the positive years and when you'll be receiving the negative years that make up that average return and the order in which you receive these returns can make a huge difference.

As famed economist Milton Friedman once observed, "You should never try to walk across a river just because it has an average depth of four feet." Some parts of the river may seem shallow enough to walk on, but one wrong step and you could drop off twenty feet underwater.

You wouldn't want to risk drowning in a river, so why should you treat your money any differently? Averages may hide dangerous realities in the stock market also.

In the stock market crash of 2008, from the top to the bottom the market fell 57% as measured by the S&P 500. Let's assume you were unlucky enough to invest $1,000,000 at the top of this market in October of 2007 and you needed to generate 5% income ($50,000) a year.

The problem you would have ran into is that when your $1,000,000 got to the bottom of that market crash in March of 2009, it was worth $432,000 assuming you hadn't started your withdrawals yet.

To keep the math simple let's assume you didn't need to take your first $50,000 withdrawal until March of 2009. (Starting sooner would make the numbers even worse)

Taking $50,000 off of $432,000 is not a 5% withdrawal rate anymore. It is now an 11.5% withdrawal rate, increasing the risk of running out of money. This illustrates how important timing is!

The sequence of return risk creates huge hazards if you are in retirement and especially if you are taking income on a stock portfolio.

The tactical approach we use to avoid this hazard is to buy, hold, and SELL. With this approach, you still invest in stocks and bonds, however, you have a sell discipline to get out the stock market when it starts to decline, instead of riding it all the way down to the bottom.

More information on our tactical approach to managing money including our exit strategy can be found on our website under Advance and Preserve.

The content is developed from sources believed to be providing accurate information. The information in this material is not intended as tax or legal advice. It may not be used for the purpose of avoiding any federal tax penalties. Please consult legal or tax professionals for specific information regarding your individual situation. The opinions expressed and material provided are for general information, and should not be considered a solicitation for the purchase or sale of any security.