Sequence-of-Return Risk: An Uncontrollable Factor to Financial Success that is Often Overlooked

It’s the reason you may end up a multimillionaire — or not — that is completely out of your —or anyone’s — hands.

INTRODUCTION

In my spare time I enjoy reading academic studies.  One recent paper focused on sequence-of-return risk.  This concept is one of our primary concerns at PFS Financial.  One of my first projects when I was just an intern in the financial field was to study two sisters retiring ten years apart, and how, with the same spending rate and investment plan, one sister prospered, and one almost ran out of money.  The only difference? The year they retired.  The older sister, who retired 10 years earlier than the second sister, was able to have a spending rate of 6% and her investments almost doubled over the decade.  The younger sister, when she retired 10 years later, with the same spending rate of 6%, almost ran out of money.  The sisters were a victim of sequence-of-return risk.

 SEQUENCE-OF-RETURN RISK EXAMPLE

Here is how sequence-of-return risk rears its ugly head.  Suppose we have two different individuals, John and Anne, both of whom work the same number of 40 years, have the same salary and salary growth, save the same amount of money, and are identically invested.  In fact, they even have identical returns – both returned 5% annualized real (above inflation, or roughly 8% nominal) after fees.  The only difference is that John began work in 1954 and Anne in 1967.  At the end of their 40-year careers, Anne has $880,000 saved and John has $590,000 saved. 

How is this possible? How is it that with everything being equal, John has $290,000 less than Anne.  How can you explain a 50% gap between John and Anne? The answer: sequence-of-return risk.

The above example is intriguing, but it represents only one sequence of history.  One of the over 240 research providers we source information from at PFS is Wells Fargo Securities.  Their research affiliates have conducted 20,000 simulations of 40-year runs of history using a stochastic – or randomly determined – process, similar to the Monte Carlo simulations that our team runs for each of our client’s plans (a Monte Carlo simulations is the use of random sampling techniques and the use of computers to obtain approximate solutions to mathematical problems). 

In those 20,000 simulations the effects of sequence-of-return risk become ever more prevalent.  If we control for a 5% annualized real return, just like John and Anne achieved, we arrive at 1,400 simulation results achieving that exact return of 5% over the 40-year history.  The highest probability of success of these 1,400 netted over $1,000,000 while the lowest probability of success for their colleague, with an identical 5% return, netted $314,000.  This is an incredible, almost unbelievable, difference.

 THE BOTTOM LINE

Sequence -of-return risk has been in the shadows for quite some time.  It is something that we focus on diligently.  Sequence-of-return risk is why our team is so focused on cash flow planning.  Using our PFS GPS Plan™ we not only run a top-down Monte Carlo simulation (described earlier) but also a bottom-up, detailed, cash flow analysis.  Studies show that if one is dependent on selling part of their portfolio to meet income needs, that the sequence of returns of a portfolio are extremely important.  We would rather not rely on such risk – risk that we cannot predict – to help ensure our clients have the cash flow they need to enjoy their quality of life. 

 IF WE CAN’T CONTROL IT, WHAT CAN WE DO?

So, what can you do with this uncontrollable sequence-of-return risk? The key is to begin to develop an understanding of what your purpose is in life which can then be translated into financial goals and objectives to help you achieve financial freedom. Once this baseline is established, sequence-of-return risk can be mitigated by your financial plan.  It is critical that your financial plan be an ongoing and dynamic plan that is vertically integrated that allows for tactical and strategic shifts, as needed. 

Finally, when structuring our tailored portfolios, we believe that future returns are the furthest thing from a “random walk.”  We believe that we can use established valuation metrics to help forecast returns and help mitigate nasty returns.  One of many valuation metrics we use is the Cyclically Adjusted P/E ratio (CAPE).  This fairly basic valuation metric indicates whether the stocks which comprise the stock market are cheap, fairly-valued, or expensive. Over time, a strategy of owning equities when the CAPE is low tends to outperform, while a strategy of owning equities when the CAPE is elevated tends to perform poorly.  We believe that there is no reliable tool to forecast in the short term – only God knows the news of today before it happens.  However, we believe such metrics are useful in allocating portfolios over the time horizon of a strategic allocation.

DISCLOSURES

The information given herein is taken from sources that IFP Advisors, LLC, dba Independent Financial Partners (IFP), IFP Securities LLC, dba Independent Financial Partners (IFP), and its advisors believe to be reliable, but it is not guaranteed by us as to accuracy or completeness. This is for informational purposes only and in no event should be construed as an offer to sell or solicitation of an offer to buy any securities or products. Please consult your tax and/or legal advisor before implementing any tax and/or legal related strategies mentioned in this publication as IFP does not provide tax and/or legal advice. Opinions expressed are subject to change without notice and do not take into account the particular investment objectives, financial situation, or needs of individual investors. This report may not be reproduced, distributed, or published by any person for any purpose without IFP’s express prior written consent.