EZV Algorithms: Sequential Return Risk And Drawdown Protection

Nov. 07, 2019 7:03 PM ETSPY, DIA, QQQ, IWM, SSO, IEF2 Comments


  • Recently an EZV Algorithms Marketplace subscriber highlighted how anyone retiring or near retirement needs to understand “sequential return risk."
  • While average returns might be good over your retirement, if the early years are negative, you could be in trouble – compounding on a smaller investment base.
  • Some people run numbers as though the world were a nice, neat continuity of returns. It’s not, and I’ll illustrate the problem.
  • Combine that risk with the lack of returns available from safer fixed-income investments, and there is a serious dilemma.
  • The obvious solution is reduced drawdown risk while generating strong returns, but how?
  • Looking for a portfolio of ideas like this one? Members of The Easy VIX get exclusive access to our model portfolio. Get started today »

Sequential Return Risk

Sequential return risk is the possibility that the combination of withdrawals and sub-par returns in the early years depletes your retirement nest egg, rendering an otherwise viable plan insolvent sometime before the full retirement horizon. In other words, the investment base depletes early and despite good average returns on the reduced balances over the period, you go broke before you die.

The problem is best illustrated by example, and I’ll ignore taxes to keep it simple. Consider Joe, a 65-year-old retiree who wants a plan that will get him through the next 25 years. (Hoping to die at 90 I guess!) He’s saved $1 million and expects to withdraw $58,000 per year at the start, escalating at 2.0% per year. Somebody tells him that if he can earn 7% annually on his investments, he’ll reach 90 years old with his full $1 million balance intact. So he runs the numbers and his plan looks like this:

Retirement Scenario - Even Distribution of Returns

Source: Michael Gettings

What could possibly go wrong? Well, suppose the first two years’ investment performance is not so good, losing 21% and 10%, respectively – a bear market. Here is what poor Joe might actually encounter despite the same average return of 7.0% over the entire period.

Source: Michael Gettings

Joe literally might be "Poor Joe" by his mid-80s, and he would be stressing over it by his early 70s – not a peaceful way to spend his golden years. Here is a summary of Joe’s sequential return risk:

Poor Joe’s Sequential Return Risk Problem

Source: Michael Gettings


Consider how Joe might mitigate his risk.

  1. He could work an extra 5 years – not his preference.
  2. He could raise his fixed-income allocations, but given bond yields, returns become paltry before risk becomes acceptable.

If you're retired or near retirement and can't afford to lose your nest egg, or if you simply want to increase returns by avoiding downturns and compounding on a larger investment base, follow the shape of the VIX futures curve for early warning signs.  Or better yet, subscribe to EZV Algorithms and get the benefit of quantitative calibrations from my artificial intelligence algorithm. Or just ride that next 20% downturn.

This article was written by

Michael Gettings profile picture
Author of EZV Algorithms
Drawdown protection and outsized returns by decoding the VIX futures curve

Mr. Gettings is CEO of RiskCentrix, a firm that specializes in the establishment of disciplined programs for commodity risk mitigation, the integration of enterprise risk programs with financial management, and support in the area of risk-cognizant strategy formulation. He has 35+ years experience, originally in regulatory affairs with a major utility, then as founder and president of a natural gas marketing and trading firm. As a consultant, for the last 20 years he has developed and implemented innovative approaches to risk assessment and mitigation for utilities, power generators, and energy-intensive industrial firms. More recently he is retired, but for occasional consulting. He manages his own portfolio using many of the quantitative methods deployed throughout his career.

Disclosure: I am/we are long SPY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I trade all the tickers mentioned using the algorithm described. The artificial intelligence algorithm monitors daily
performance and periodically recalibrates look-back horizons and triggers in a step-wise sequence. New calibrations are applied prospectively only, and never applied to the historical period from which they derived. The algorithm described and the discussions herein are intended to provide a perspective on the probability of outcomes based on historical performance. Neither modeled performance nor past performance are any guarantee of future results.

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