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Gabriel Lalonde
May 11th, 2022

How Does the Sequence of Returns Risk Work?

Most Ottawa Certified Financial Planners often advise their client investors to set up, run, and maintain a well-diversified portfolio that matches their risk tolerance levels. Such portfolios may be adjusted to suit a change in the status quo or new market conditions. But this advice is not absolute. In some cases, it may not be the best call for investors who are close to retirement. While every investor wants to generate high returns, it is not the only factor determining how well savings last or portfolios perform.

In other words, the dollar value of an average portfolio will drop with every withdrawal. So, having negative returns in the early days of any portfolio may deplete savings to zero sooner than if the portfolio performed better and recorded positive returns early. Considering how crucial returns are to investors, everyone wants to stay on the safe side by working towards positive returns only.

Two Hypothetical Situations.

Let’s imagine two situations. In both situations, a new retiree with a $1 million starting capital is looking to withdraw $50,000 annually. However, the only difference is in the sequence of returns, reversed in one and unchanged in the other.

We will assign hypothetical names Mr. A and Mr. B to both retirees. Mr. A will record positive returns from the onset of his retirement years. In contrast, Mr. B will record negative returns in the early days.

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There is nothing to differentiate both retirees regarding the annual average growth rate. The same would be the case if there were no withdrawals; that is, the final dollar amounts would remain unchanged. But in this case, there were withdrawals but in different sequences. Mr. B had a shortfall at 83, while Mr. B ended with over $2.5 million at 90.

In Conclusion

Having understood how risk sequence can affect the end goal, the next important question is how to get it right with the sequence of returns risk. Well, there is only one method to minimize the effects of market volatility; and that is diversifying into multiple asset classes with no correlation. This can create lower portfolio volatility, mainly when it is close to the decumulation years. It is a failsafe way to mitigate the risk of drawing down on assets while generating income in a bear market.

It is important to note that the hypothetical numbers above are extreme – this will most likely not happen in an actual market situation. However, they are clear indications of how the sequence of returns of an investment portfolio experiencing withdrawals can affect the end goal of any new retiree.

You should talk to your Ottawa CFP if you are unsure how to manage this risk. These professionals are always open to offering expert advice that suits your situation the most.

Gab

About Gabriel Lalonde, CFP, CFEI, B.A.

When Gabriel is not crunching numbers, you can find him accompanied by his beautiful wife Ana and son Théo, either on the golf course in the summer or the ski slopes in the winter. His dream has always been to take over the family business as he saw first hand how much impact his father had on shaping peoples lives and creating long lasting legacies. Gabriel has a true passion for financial literacy and he believes everyone should have access to solid financial education.

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