Retirees are faced with many financial planning concerns as they approach retirement and throughout their golden years. Among those risks is one of the most overlooked concerns, and possibly the most significant, which is often referred to as the “sequence of returns risk”.
Sequence of returns refers not to the average return an investor may experience, but the order in which those annual returns might occur. Typically, investments are quoted based on their historical average return. If an investor presumes that such returns will be replicated in the future, this can lead to some potentially damaging assumptions in their retirement projections.
Historically and given enough time, broad market indices typically tend to reproduce returns that are fairly consistent with their longer term averages. In regard to a specific investment, there is never a guarantee that any individual specific security will replicate its recent returns. However, that risk is independent of facing a negative sequence in your investment portfolio.
In order to have a very basic understanding of how a negative sequence may affect an investor’s portfolio, we must examine a basic flaw in financial planning that is often made by novice investors. Let’s assume that as an investor your portfolio will produce an average return of 8% per year for the next 30 years. At first glance, that would indicate that spending 7% of your investments annually in order to help provide for your retirement income would be sufficient, and leave you accumulating an additional 1% per year on your principal. After all, 8-7=1.
Unfortunately in financial planning, the math is not quite that simple. As any semi-experienced investor is likely already aware, an average investment return of 8% per year is not likely 8% each year for 30 years. Due to the nature of how markets function, volatility will most certainly dictate that your returns were a random set of results that ultimately produced this average return of 8%. This will incorporate years which were better or worse than the average, as well as some years which were negative returns.