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When Is Market Volatility Most Dangerous?

When Is Market Volatility Most Dangerous?

Though a market downturn generally isn't fun

for most people, its timing can have a greater

impact on some investors than on others. For

example, a market downturn can have greater

significance for retirees than for those who are

still accumulating assets. And it has the most

impact if it occurs early in retirement. Why?

Because of something known as the "sequence

of returns"--basically, the order in which events

affect a portfolio.

For retirees, timing is everything

To understand the importance of the sequence

of returns, let's look at two hypothetical retirees,

both of whom start retirement with a $200,000

portfolio. Each year on January 1, Jim

withdraws $10,000 for living expenses; so does

Pam. During the first 10 years, each earns an

average annualized 6% return (though the

actual yearly returns fluctuate), and both

experience a 3-year bear market. With the

same average annual returns, the same

withdrawals, and the same bear market, both

should end up with the same balance, right?

They don't, and here's why: though both

portfolios earned the same annual returns, the

order in which those returns were received was

reversed. The 3-year decline hit Jim in the first

3 years; Pam went through the bear market at

the end of her 10 years.

Jim's Return Jim's Balance Pam's Return Pam's Balance

Year 1 -5% $180,500 15% $218,500

Year 2 -2% $167,090 12% $233,520

Year 3 -1% $155,519 14% $254,813

Year 4 3% $149,885 8% $264,398

Year 5 7% $149,677 9% $277,294

Year 6 9% $152,247 7% $286,004

Year 7 8% $153,627 3% $284,284

Year 8 14% $163,735 -1% $271,541

Year 9 12% $172,183 -2% $256,311

Year 10 15% $186,511 -5% $233,995

As you can see, Pam's account balance at the

end of 10 years is more than $47,000 higher

than Jim's. That means that even if both

portfolios earned no return at all in the future,

Pam would be able to continue to withdraw her

$10,000 a year for almost 5 years longer than

Jim. This is a hypothetical example for

illustrative purposes only, of course, and

doesn't represent the results of any actual

investment, but it demonstrates the timing

challenge new retirees can face.

Weighing income and longevity

If you're in or near retirement, you have to think

both short-term and long-term. You need to

consider not only your own longevity, but also

whether your portfolio will last as long as you

do. To do that requires balancing portfolio

longevity with the need for immediate income.

The math involved in the sequence of returns

dictates that if you're either withdrawing money

from your portfolio or about to start, you'll want

to pay especially close attention to the level of

risk you face. After the 2008 market crash,

many individual investors fled equities and

invested instead in bonds. Along with actions

by the Federal Reserve, that demand helped

push interest rates to all-time lows.

However, when interest rates begin to rise,

investors will face falling bond prices. And yet if

you avoid both stocks and bonds entirely,

current super-low interest rates might not

provide enough income. Achieving the right

combination of safety, income, and growth is

one of the key tasks of retirement investing.

Seeking balance

You obviously can't control the timing of a

market downturn, but you might have some

control over its long-term impact on your

portfolio. If your timing is flexible and you're

unlucky enough to get hit with a downturn at the

wrong time, you might consider postponing

retirement until the worst has passed. Any

additional earnings obviously will help rebuild

your portfolio, while postponing withdrawals

might help soften any impact from an

unfortunate sequence of returns. And reducing

withdrawal amounts, especially in the early

retirement years, also could help your portfolio

heal more quickly.