Sequence of returns (SoR) risk refers to the situation when the market experiences random movements in such a way that returns are not uniformly distributed. For example, in the 32-year period from 1966 to 1997, the DJIA had an annualized return of 8%. However, the returns were not evenly distributed over time. For the first half of this period, from 1966 to 1981, the Dow began at 1,000 and ended at about the same level. Then, from 1982 through 1997, the Dow grew over 15% per year, taking the index from 1,000 to about 8,000.
In a recent book “Adaptive Asset Allocation: Dynamic Global Portfolios to Profit in Good Times—and Bad,” by Adam Butler, Michael Philbrick, and Rodrigo Gordillo, the authors looked at the DJIA history from 1966 to 1997 and performed an interesting thought experiment.
They divided the period into two halves: 1966-1981 and 1982-1997. For a retiree who retired in 1966, according to the historical order of the returns, they stipulated an initial portfolio balance of USD 3 million and monthly spending of USD 16,200, on an inflation-adjusted basis. Based on this withdrawal strategy, in 12 short years, by 1978, the money was gone. They then reversed the order of the sequence of returns as follows: the strongly surging market from 1982 to 1997 first, followed by the volatile sideways market from 1966 to 1981. In this scenario, the retiree was able to withdraw the desired income each year, adjusted for inflation, and still end up with over roughly USD 6 million in terminal wealth at the end of 1997.
This thought experiment illustrates the benefit of having a period of good returns early in one’s retirement; whereas, in the opposite case, when one experiences a period of bad returns later in one’s retirement, it may result in financial ruin.
For retirees who began their retirement shortly before years of major market corrections, such as the market crash in 1987 and the Great Recession of 2008, their retirement funds may be gravely affected, due to the exposure to downside risk. To help mitigate SoR risk, particularly given that no one can foretell the timing of adverse market events, it would be prudent to allocate a few years’ worth of spending needs in non-volatile accounts, specifically earmarked for the first few years in one’s retirement, in order to avoid SoR risk.
 Adam Butler, M. Philbrick, R. Gordillo, Adaptive Asset Allocation: Dynamic Global Portfolios to Profit in Good Times – and Bad, 2016. John Wiley & Sons, Inc.: Hoboken, New Jersey.The posts on this blog are opinions, not advice. Please read our Disclaimers.