Sequence Of Returns - A Bigger Risk Than You Think: Financial Advisors' Daily Digest

by: SA Gil Weinreich

Summary

Alpha Gen Capital makes an uncommonly noted but logically compelling claim that sequence risk is as present in investors' accumulation phase as their retirement phase.

Jesse Felder: Utilities stocks just did something that should only happen once in 1,200 years.

New contributor Jordan Kimmel on identifying and investing in trustworthy companies.

On today's Seeking Alpha, contributor Alpha Gen Capital discusses a classic retirement risk known as "sequence of returns" risk - and makes what I think is a logically unassailable point that the risk is as present for the accumulation phase of investing as it is for the retirement phase.

Conventionally understood, sequence of returns refers to the critical performance of the market in the years just before and after retirement. An investor retiring with a $1,000,000 stash in 1995 right before the dot-com run that lasted five years would have seen enormous investment account growth compared to someone retiring into a 2008-style market crash with the same amount. Both retirees may have anticipated an annual draw of, say, $50,000 per year, but because of their unique timing, the former would likely be able to lavishly increase spending for an anticipated 30-year retirement while the latter would have to curtail spending sharply for the rest of his life.

Comes along Alpha Gen Capital to make the following undiscussed but obvious point:

Even though the annual return of the S&P 500 has been 8% annually, there have been periods of significant outperformance and underperformance. Starting their career in 1979 and working for 30 years will shows a substantially different ending balance than a person starting in 1950, and working for thirty years.

Using those start dates, and a $30,000 starting salary, the difference between the two savers is almost one-third."

Not only is this (again) obvious point not generally discussed, but the author points out how the investment industry is even known to make the opposite point in its marketing literature (Click here to see the article along with a real-life example of this sort of misinformation).

The truth is that sequence risk is a part and parcel of life itself, and as such, extends beyond retirement income and investment accumulation cases offered by Alpha Gen Capital. For example, SA contributor Dirk Cotton noted in an article published last year that financial advisors would do well to plan clients' retirement based on the likelihood that their sequence of consumption is far from linear.

Think about it. How many investors (or advisors) on SA are dedicated to achieving that "paycheck" of 4% annual income withdrawals. And yet, the reality of an unexpected surgery, an inheritance or what have you introduces volatility in people's actual spending patterns.

The wise king Solomon long ago noted this phenomenon, saying:

…not to the swift goes the race nor the war to the mighty; neither do the wise have bread nor the understanding wealth, nor the knowledgeable favor; rather time and chance happen to them all." (Ecclesiastes 9:11)

The un-plannability of life doesn't mean that financial planners have no business being in business. To the contrary, the effort to impose order upon chaos is all the more worthwhile. But greater awareness of the limitations of our models can only help, and an expansion of our knowledge (per the above-cited articles) similarly aids advisors.

I've gone on long enough here. My questions to readers are: What do you see as the key takeaways of sequence risk in investing and retirement, income and spending? What does it mean for investors and what does it mean for advisors? Please add your thoughts in the comments section.

Meanwhile, here are a few advisor-related links with which to begin your workweek: