Do not ignore sequence of returns risk.
Sequence of returns risk can make or break your plans of becoming and remaining financially independent or retired.
What determines our investment success? Silly question! Returns, of course! The higher the average compound return the higher your final portfolio value. Indeed, for buy-and-hold investors, the compound average growth rate (CAGR) of your portfolio is the only determinant of the final portfolio value.
However, in the real world, we are rarely just buy-and-hold investors. While saving for retirement we make regular contributions and in retirement, we take regular withdrawals from our nest egg. The additional cash flows into and out of the portfolio now imply that the sequence of returns over your investment and retirement horizon will have an impact on how well we do with our investments.
Hence the name sequence of returns risk.
Especially for retirees, the sustainability of our withdrawal strategy could be severely compromised if we retire around the peak of the market and right before a major bear market. Even if the market eventually recovers again, the fact that we were withdrawing from our portfolio while prices are depressed means that we deplete our nest egg so much more rapidly.
It means we’re burning the candle of our retirement nest egg on both ends, essentially, it’s the opposite of dollar cost averaging! In fact, all past instances where the 4% Rule would have failed are attributable to weak returns early on during retirement, e.g., the Great Depression and the 1970s and early 1980s.
Fiology thanks the FI community’s subject expert Karsten “Big Ern” Jeske of Early Retirement Now for shaping this lesson.
- Sequence Risk and Dollar Cost Averaging at investopedia.com
- How Much Money Do I Need to Be Financially Independent? at fiology.com
- Understanding Sequence Of Returns Risk – Safe Withdrawal Rates, Bear Market Crashes, And Bad Decades by Michael Kitses of kitces.com
- The Ultimate Guide to Safe Withdrawal Rates – Part 14: Sequence of Return Risk by Karsten “Big Ern” Jeske of earlyretirementnow.com
- The Ultimate Guide to Safe Withdrawal Rates – Part 15: More Thoughts on Sequence of Returns Risk by Karsten “Big Ern” Jeske of earlyretirementnow.com
- 035 | Sequence Of Return Risk | Early Retirement Now by Brad Barrett and Jonathan Mendonsa of choosefi.com
- Sequence of Returns Risk impacts savers and retirees differently, thus, there are also different recommendations:
- Don’t sweat sequence risk (too much): If you are just starting your path to save for retirement or even if you’re three to five years away from retirement the prospect of a bear market around the corner is a lot less concerning. If the drop in the stock market is followed by a swift recovery as has been common historically, you can even greatly benefit from that scenario through dollar cost averaging!
The Current and soon-to-be-retired:
- Thinking about retiring as soon as you hit your FI number, i.e., 25x expenses? Don’t be too impatient about retiring. You might set yourself up for failure because you are more likely to retire at the market peak right before Sequence Risk strikes again. It might be best to target a higher savings target (i.e., a lower safe withdrawal rate) just to be sure.
- Retirees might consider a bond glidepath: Pick a higher bond share early on to hedge against bad equity returns during the first few years of retirement. But shift back into equities again because we need equities with their much higher expected return to sustain a retirement over the decades.
- Another way to mitigate Sequence Risk would be to tie the withdrawal rates to financial fundamentals, especially stock valuations like the Shiller CAPE Ratio. Withdraw a lower percentage from the portfolio when equities are expensive and a drawdown is more likely, but then also increase the withdrawal percentage after stocks drop and valuations become more attractive again.
- The Ultimate Guide to Safe Withdrawal Rates – Part 22: Can the “Simple Math” make retirement more difficult? by Karsten “Big Ern” Jeske of earlyretirementnow.com
- The Ultimate Guide to Safe Withdrawal Rates – Part 19: Equity Glidepaths in Retirement by Karsten “Big Ern” Jeske of earlyretirementnow.com
- The Ultimate Guide to Safe Withdrawal Rates – Part 20: More Thoughts on Equity Glidepaths by Karsten “Big Ern” Jeske of earlyretirementnow.com
- CAPE ratio historical data by Robert Shiller of econ.yale.edu
- The Ultimate Guide to Safe Withdrawal Rates – Part 18: Flexibility and the Mechanics of CAPE-Based Rules by Karsten “Big Ern” Jeske of earlyretirementnow.com
- 066 | The Emergency Fund…Is It A Bad Idea? | Big ERN The Reveal by Brad Barrett and Jonathan Mendonsa of choosefi.com
“Any goal worth achieving involves an element of risk.” – Dean Karnazes