Despite all of the calculations involved in investing, there is still an element of luck involved. A specific term for this luck is, “Sequence of Returns”. What on earth is that? Answer: it is a risk. And it may just be the most important concept in the world if you ever wish to spend your savings — and have them last as long as you need.
The topic became relevant recently when a client asked me to assist in defining what their “concerns” should be for the long-term, now that they had accumulated a decent amount of savings and investments. The desire was to continue to accumulate savings but, more important, have the monies last at least long enough to see their plan to fruition for themselves and their kids.
Obviously there are numerous risks and concerns with any portfolio or plan, large or small. But knowledge of what risks to be concerned about is critical. One of these risks is “sequence of returns”. The term is not as complicated as it may sound. Sequence is a fancy word for timing. Returns means what the portfolio earns, whether negative or positive. So, the timing of negative or positive returns becomes a significant risk when you begin to spend your portfolio rather than continue to plow money into it.
Yes, at some point, most of us will actually spend the money we worked our butts off to save. This spending will happen sooner or later, (and you may already be in that stage!) but optimally at a time when the portfolio can afford to be spent. Have you ever heard of the “4% Rule“? The concept of being able to — someday — comfortably spend 4% of a portfolio year in and year out while still being able to preserve that “nest egg” portfolio? For example, if you accumulate $1,000,000 someday, then move into “spend” mode, this equates to being able to spend $40,000 per year from the portfolio and preserve the $1,000,000 nest egg. Accumulations of $5,000,000 and more still mean similar math and it is tempting to spend more than the 4%, or $200,000 per year.
BUT (there is always a “but”) — what if, at the time you decide to retire or spend a chunk of the money, the market return is suddenly negative? And not just negative but like 2008-2009 negative? That timing — or “sequence of [negative] returns” — would be really poor! This is a true story and I have experienced it with clients. One of the keys is to be flexible. Flexible in terms of timing of retirement and flexible, most important, in terms of how much you spend.
Here is where luck comes in. And we all know that luck is mostly unpredictable and comes in good varieties and bad. You could have been “good lucky” and stopped working in 2016 — with two amazing years of stock returns to boost your nest egg right from the start. OR, you could have been out of work in 2007 and 2008 (bad luck) where you had to hunker down not able to buy new things or not buy a bigger house… or worse.
But do not become discouraged; there are ways around planning for both good and bad luck! The simplest of things is having an emergency fund or “buffer” of cash available. The more complicated solutions involve types of income guaranteed by insurance or annuity contracts. And there are all sorts of solutions in between.
Understand “sequence of returns” and please let me know if I can break it down for you. Planning is one of the best defenses against bad luck. More on flexibility in a future edition of TGIF 2 Minutes.