How to manage sequence of returns risk

The assumption that most investors make is that these will even out in time – that the well-observed tendency for markets to rise over the long term will compensate for short-term declines along the way.

But this assumption can be cruelly misplaced – especially when a bear market coincides with the start of retirement.

The crucial concept here is ‘sequence-of-return risk’.

In essence, the order in which an investment portfolio encounters rises and falls in the market can have a dramatic effect on outcomes – so that the end-value of one portfolio may be very different from another even if the sequence of returns they have experienced has been only slightly different. 

This is because the compounding principle works against investors who are making withdrawals during bear markets.

When you invest into rising markets, you harness the power of compound interest; your capital earns interest, and then the next year it earns interest on both its initial value and the interest reinvested. 

But if you start making withdrawals from your pension fund at a time when markets are falling, you become a victim, rather than a beneficiary, of compounding.

It is not just the withdrawal that is gone, but so too are the future returns that that money might have generated had it been left invested. 

The difference a year makes

We can illustrate this with two hypothetical investors.

We use US data, not least because the US market affords the long-run, real-world information needed to show the full effects of SORR over time, but the maths does not lie and it applies everywhere.  

The first investor retired in January 1973, at the start of the seventh-most severe bear market in US history. The second retired a year later, in 1974, the year in which the bear market reached its bottom and began to recover. Both expected retirement to last for 35 years.

Let’s assume that both entered retirement with $500,000 invested in a portfolio equally split between US equities and US bonds, an assumption that again allows us to assemble real-world data as international investment was uncommon at that time.

We should also assume that the portfolio was rebalanced each month and that both investors planned to withdraw $25,000 each year, adjusted for inflation. 

The retirements of the two investors overlap for 34 of their 35 years.

If neither investor had made withdrawals over the course of their retirement periods, the returns they made would have been broadly similar: a 5.23 per cent real return per year for the 1973 retiree and a 5.10 per cent real return for the 1974 retiree.