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Air raid poster as a metaphor for avoiding market risk

Everyone assumes it won’t happen to them. But from history we know that not everybody is so lucky.

No, not jury service. I’m talking about sequence of returns risk. The unluckiest break that derails your financial future and throws cold water on your FIRE1.

Sequence of returns risk is the risk of earning negative portfolio returns shortly before or after you retire. It’s a dangerous situation created when you start withdrawing money from a portfolio that’s seen little to no growth, only shrinkage.

Consider the following graphics from Axa Equitable [PDF].

The first charts the fortunes of three investors over three different time periods. All start with a $1 million portfolio that grows for 25 years.

Each investor experiences a different market cycle. But – neatly for the example – all three enjoy the same 6% average annual return:

The maths means the route doesn’t change the destination. With no withdrawals and the same average annual return, everyone ends up at the same place.

But what about with withdrawals?

We assume the same investors start with $1 million each once again. They live through the same cycles as before. The average portfolio return is again 6%.

Déjà vu? Don’t worry, things are about to get interesting.

This time each investor withdraws $50,000 a year from their portfolio:

The difference is stark. The portfolio returns are the same. And Mr Green still leaves a fabulous $2.5m legacy.

But now Mr Blue goes bankrupt!

Regularly taking money out of the portfolios vastly changed the outcome.

Mr Blue’s first three years of withdrawals coincided with a crash. He never recovered.

However the same three bad years came at the end for Mr Green. It scythed his portfolio, but it had already grown substantially by then.

That is sequence of returns risk.

A different mindset

Not selling as an accumulator is fairly easy. All crashes are buying opportunities with a long enough time horizon. Why not grab a bargain?

However a de-accumulator must – by definition – be taking money from their portfolio.

And sequence of returns risk means that a few early bad years for the markets – combined with withdrawals – can torpedo your long-term prospects.

Sure, even after an early bear market a decent portfolio should eventually start growing again.

But for an unlucky few, the damage is done. You’ll be a failure case. In 20 years or so you’ll run out of money.

You’re already dead. You just don’t know it yet.

SWR versus sequence of returns

Let’s not be too gloomy. The initial sustainable withdrawal rate (SWR) research was aimed squarely at these issues. It estimated how much you could spend while being confident (if not certain) that your portfolio would outlast you.

The data that fed into the SWR research included some truly dire periods. Depressions and wars.

Yet choose a low enough withdrawal rate and the data shows that – historically – everyone made it.

Even those those who retired into a bloodbath for shares!

However most people – especially early retirees – can’t withdraw a very low 2% a year. Their portfolios are too small.

Luckily you can ratchet SWRs up a lot and still hit 95% forecast success rates.

So most people do that. We assume we’ll withdraw around 4%, say, and 19 cycles out of 20 we’ll be okay.

In the good times we forget that means 5% weren’t okay. They failed.2

The opposite is a fat streak. Your portfolio doubles, and doubles again. You spend with abandon. You leave your grandchildren a fortune. Those grandchildren tell everyone about their grandpa who retired at 50 and died rich. Someone writes an article about your investing smarts. Your portrait beams.

I hope that happens to us.

But this post is about avoiding joining the blighted failure cases – before it’s too late.

Retiring into a market that’s falling fast or an economy where high inflation threatens to savage your real returns?

Let’s consider your options.

Easy mode: watch but do nothing (yet)

Let’s say markets are down. A lot. But it’s not yet a long dream-crushing bear market.

Inflation may be stubbornly high. But it’s not yet an era of high inflation – let alone hyperinflation.

Should you act?

A good financial plan and asset allocation anticipates turbulence. Maybe you can grip the armrests tighter rather than parachuting at the first wobble.

Consider it a watching brief. Like when a suspect lump seems benign but your doctor says to keep an eye on it.

Most market upsets quickly pass and are soon forgotten. Look at Michael Batnick’s chart:

Click to enlarge the drama…

Source: The Irrelevant Investor

Not every investing herring turns out to be red – that’s the point of sequence of returns risk.

But depending on how you’d respond to a scare, it may be best to pause and ponder.

Pausing your plan

Reminder: if you’re in the saving and investing phase, keep at it. This post is not about putting everyday accumulation on hold. (Buy more shares in bear markets. You’ll end up richer.)

It’s only those drawing down their savings – or those getting close to the transition – who should consider acting if a bear market strikes, especially in the early years of retirement.

As we’ve just seen there are always worries in markets. Few threaten a solid retirement plan.

But some do. And it’s not obvious which ones in advance.

Consider 2020. It was a banner year for stock market returns. Spending fell so people saved more, too. Some people also got government assistance.

But we only know all that good stuff now. For much of the year people were frightened.

Who could fault somebody who retired in 2019 and panicked in March 2020?

Shares had cratered. A new illness was killing thousands. Governments were turning economies off. Many expected a global depression.

Personally I didn’t think it was the end of the world. But a threat to a new retiree’s long-term financial future? That was a far harder call.

So let’s be humble and pragmatic and consider some options.

Work one more year (or two)

Somebody has to say it. Maybe if a bear market is raging, keep working?

One more year is a curse in the FIRE community.

But truly bad periods for sequence of return risk are rare and damaging. Trying to avoid them is worth considering.

Stay employed longer due to a falling market and you won’t spend from a depleting portfolio. You could even add to it. Things should look better on the other side.

There are two snags.

Firstly, it may not be better on the other side. At least not anytime soon. Some bear markets last for years. What if you end up throwing several more years into the work furnace?

I’ve no idea how you’d feel. Some would-be retirees like their jobs. Some are killed by them.

But I know for sure you won’t get those years back.

Second snag: maybe it was a false alarm.

The good news is you’ll be richer when you do retire. But again you can’t get that time back.

Also you’re still exposed to sequence of return risk when you finally do retire. Albeit with more assets as a cushion after a year or two extra at work and some portfolio growth.

Go back to your old job

If you recently left work, you’ll never be more employable again.

Perhaps rewind the tape for a year or two if you’re having second thoughts.

Acquire more money

Sequence of returns risk hurts when you spend assets that have shrunk too far, too fast.

Continuing with employment avoids that. Instead of spending from the portfolio, you’ll save more.

But what if you can’t hack your job any longer?

Well there are other ways to get spending money.

Downsize your home

Many retirees plan to downsize someday. Where practical, bringing forward such plans can release cash to tide you through an early bad market.

If a stock market downturn coincides with a recession, downsize sooner rather than later if you’re going to do this.

Remember: you’re taking capital out of the property market. Not moving up the ladder. So do it when prices are buoyant to get the most cash.

Take a part-time job

Okay, so you can no longer stomach the nine to five to email before bed. But what about the ten to two? Or the Monday to Thursday?

A managed retreat from work keeps some money coming in for longer. Again, that could reduce or eliminate a fatal drawdown of your capital.

High-end information workers are blessed here. The word you’re looking for is ‘consultant’. Sweat that intellectual capital while you still have some!

Skilled tradespeople might transition to part-time pretty easily, too.

But middle-managers who owed their income to recently forfeited fiefdoms could struggle.

Enter the gig economy

The jury is out on the uber-flexible gig economy. Are today’s young workers getting a raw deal?

Maybe.

But for a workplace refugee in a bear market, the gig economy could be a lifeline.

Drive an Uber. Deliver for Deliveroo. Rent out a room on AirBnB. Whatever works for you.

It won’t be lucrative compared to your old salary. It probably doesn’t need to be.

I’ve explained before how just a little income is worth more than you think.

A few hours earning £100 a week equals £5,000-ish a year, ignoring taxes. You’d probably need over £100,000 in capital to generate the same income, depending on your SWR.

Spending your gig earnings to reduce your withdrawals could take the edge off a nasty sequence of returns.

Debt or other reserves

Now we get to what’s probably the least good option in the ‘mo money!’ category.

Best case: maybe you could hurry along an expected inheritance or some other bequest. There may even be taxes advantages.

Middling good/bad would be to drawdown cash from an offset mortgage. You’re taking on new debt, and increasing your monthly outgoings due to interest. Not ideal. (You’d also probably have to have arranged the offset mortgage years in advance while working. It may not be an option now.)

The benefit of releasing cash is your investment portfolio then requires less raiding for liquid spending money. Just remember to rebuild your offset mortgage pot ASAP when the markets bounce. (And acknowledge the risk that it might not bounce to your schedule.)

Beyond that are even worse options. Borrowing from family or friends. Raising cash on margin against your portfolio. (I wouldn’t, too risky). Equity release.

I’d cut my spending instead.

Tweak your investing strategy

Again, a market wobble isn’t unusual or necessarily an emergency. A good plan should be ready for rough patches.

Maybe you’ll spend a cash reserve first. Next you’ll sell your bonds. Equities last. They may even have bounced by the time you have to sell some.

Or perhaps you plan to live solely off portfolio income, and not sell your principal? Fine but this isn’t a free lunch. Inflation can outrun dividend growth for starters, and dividends can be cut. Though at least you’re not a forced seller of shares.

But however good your plan, as the German field marshal Moltke the Elder is often paraphrased: no plan survives contact with the enemy.

Or maybe you didn’t have a great plan anyway. With the market falling you see you were winging it. Or you were over-optimistic. Or maybe you’re less risk-tolerant than you thought.

Lower your sustainable withdrawal rate

What about a lower sustainable withdrawal rate? Success or failure can turn on small tweaks. Target 3.5% as your initial spend instead of 4% and you might never run out of money.

Consider a US investor spending $40,000 a year from a million dollar portfolio over 30 years. She would have have run out of money six times in 121 historical cycles, according to the FIRECalc tool:

However cut that withdrawal amount by just $3,000 to $37,000 and only one period saw a failure.

At $35,000 a year there were no failures.

Don’t get hung up on these specifics. This is historical data. The future is unknowable. The point is lowering your SWR by whatever you can manage will boost your chances.

Note that for long-term security you don’t just reduce your SWR during the early bearish years and then ramp it back up. The maths compounds from a lower spending base over a full retirement.

You were unlucky enough to retire into a market crash. So digest it and move on.

(Perhaps if the stock market gets truly euphoric you could reduce risk and readjust. But don’t rush!)

Take more risk

This is a bit counterintuitive and won’t work for most. But selling more of your safe assets to buy equities during a downturn should see you climb faster and higher on the other side.

Assuming you make it…

It won’t be easy. You’ll be taking stuffing out of your safety cushion to buy what’s reeking havoc. And you must have enough safe assets to spend your way through, so this is only an option for the wealthy. There are no guarantees it will work either – especially not quickly.

I could imagine doing this, but that’s after a lifetime of very active investing. Most should consider other options.

Take a bit less risk

You wanted a feature-rich retirement. You also wanted to leave a chunky legacy. The sun was shining and markets were flying.

So you exited the workforce with an aggressive portfolio – 80% in equities.

The first Monday out of work shares fell. By the end of the week they’re off 10%.

You panic.

There’s no shame in learning your true risk tolerance later than is ideal. It’s better than denial. Investing when you have a regular salary is very different to shepherding a pot of worldly wealth.

You are where you are.

Now, nobody wants to sell when markets are down. You’re locking in losses.

But it’s better to take limited action when shares are 10% off than to capitulate after a 50% decline.

If you’re rich enough, consider swapping shares for cash and bonds until you feel comfortable again. Do not abandon shares completely. Nearly all of us need some equities to meet our portfolio goals. But try to immunise yourself against freaking out at further falls.

(Then maybe turn off the stock market news.)

It might also be worth looking at an annuity. Especially if you’re a not-so-early retiree.

Annuities can provide a low but very safe floor to your income drawdown strategy. That’s valuable.

What not to do

Don’t punt on cryptocurrencies or buy NFTs to make good your losses. Don’t bet at the races.

I’m also not talking about tactically selling your shares, hoping to repurchase them when the falls are done and the sequence of returns turns to your advantage.

If you could be confident of making that operation work you’d already know it. You probably can’t.

More likely you’ll lock in losses and then miss the rebound. Maybe you’ll spend years waiting for a second bite. Your entire strategy is now derailed.

Market timing will cost most people more than they ever make. It’ll also turn your hair grey.

Cut your spending

Your wealth is down. Your portfolio is shrinking. But you need income from it to get by.

So spend less money and then you’ll need less of an income.

If you’re a fancy sort, you’re adopting a tactical withdrawal strategy, dontyaknow.

If you’re a simpler soul like moi, you’ll cancel your foreign holiday, put off buying a new laptop, and rediscover your inner graduate student.

Live well but cheaply until the tough times pass. It’s not so hard. (Especially if you own your home).

There are innumerable ways to reduce your outgoings. Doing so probably got you here.

Just remember retirement spending is a thorny problem not simply due to the risk of running out of money. There’s also the ‘danger’ of leaving lots of leftover money at the cemetery gates.

Because sequence of returns risk cannot ever be known perfectly, you may be making unnecessary sacrifices. Some postponed opportunities (travel, say) will eventually recede completely.

Many retirement plans assume your pot will go to nowt. If your plan does, get used to it.

The ideas in this article aim to reduce the risk of accelerating the march to zero due to an unlucky early knock. The aim is not to abandon your plan whenever your portfolio wobbles a few percent.

Down but not out

If you’re vulnerable to sequence of return risk when a bear market strikes – newly-retired, smaller portfolio, early exit from work, few other resources – I’d consider acting to protect your future.

By pick-and-mixing a few evasive measures, you could reduce your exposure to sequence of returns risk without too much pain, even if your portfolio has been shellacked.

For example you could reduce your long-term SWR by 0.25%, work a day a week, and swap one meal out a month in your budget for an M&S Meal Deal.

Perhaps that would make all the difference?

This is not an exact science. That’s why I haven’t bothered with spurious calculations in this article.

Nobody knows the future.

A bad market can turn on a dime. Perhaps you’d have been fine, after all.

Rather it’s all about risk reduction.

If today’s crash is tomorrow’s false alarm, no harm done. You’re better-placed going forward. You can enjoy swankier remaining years than you’d originally planned for.

Conversely if it’s not a false alarm, you’ll be glad you did something early.

Better safe than sorry.

  1. Financial Independence Retire Early. []
  2. Don’t dwell on the exact details here. I’m just illustrating with round numbers for simplicity and because the future is unknowable anyway. []
{ 33 comments }

Weekend reading: Tears for fears

Weekend reading logo

What caught my eye this week.

A reader, John, emailed me about an old article this week. He pointed to a spreadsheet function could be used to calculate the cash component of a DIY guaranteed equity bond.

If you’re thinking “what’s that?” you won’t be alone.

That article was published in 2010. Memories of the huge financial crash were still fresh. Many people I knew were scared of putting new money into markets.

Enter the guaranteed equity bond!

Varitations of this financial product – widely-trumputed in swanky newspaper adverts at the time – promised to almost always return your money to you a few years hence, as well as giving you some of the gains on a stock market index.

Of course it wasn’t called the Almost Always Bond. But the small print contained strange catches and odd hurdles. These meant you could indeed get less back than you put in.

In addition dividends were usually ignored in the return calculation. And there was also little if any mention of the fees the financial provider would enjoy.

The bond was constructed out of derivatives contracts. Hence those specifics in the terms and conditions. I’d strongly suggest the target market for a product like this is poorly-placed to evaluate the odds of the FTSE 100 being above 8,235 on a particular day in March 2025, for example – as if anyone really can. But that implicit calculation was in the mix.

My piece explained how to create nearly the same thing for yourself from a mix of cash and a tracker fund. But with none of the complexity and opacity.

Shout

I considered updating my article for 2022, working in John’s technique. (John suggested using the CUMIPMT function from the free LibreOffice spreadsheet tool, if you’re curious).

But then I realized it has been years since I’ve seen an advert for a guaranteed equity bond.

I’m sure they still exist. But back in 2010 they were ubiquitous!

Perhaps there is a role for such a product – if appropriately demystified for the average person.

But what drives the marketing of them is clearly customer demand, not present utility.

Head Over Heels

Last year saw stock markets hit high after high. Remember all the articles about peak US valuations and a tech stock bubble and the general mayhem and euphoria?

If there was ever a time to consider investing in a product that capped your gains in exchange for protecting you from at least some of a crash, this was it.

But I don’t remember the financial services industry riding to the rescue with a marketing blitz for guaranteed equity bonds.

Doubtless it knew punters wanted more excitement and risk in a bubbly market. Not a crash bag.

Mad World

Should shares continue to turn down with rate rises, inflation, and war, then eventually we’re bound to see another moment in the sun for products that promise investing alchemy.

As Josh Brown puts it:

As you’re reading this, someone is hard at work in a lab somewhere cooking up the next big idea in Upside Minus Downside technology.

It might be an ETF. It might be a hedge fund. […] A structured note.

Who knows what form it could take next time?

The details will change, the wrapper will seem revolutionary, but the underlying idea will be a story as old as time.

And it will captivate the minds of some of the most intelligent people around. Doctors, lawyers, bankers, brokers, scientists, builders, politicians. None of us are completely impervious to a story that good.

Have a great weekend!

[continue reading…]

{ 13 comments }

InvestEngine review

InvestEngine review post image

The online broker InvestEngine offers ETF investing in DIY or robo-advice flavours. It’s beginner-friendly and suitable for veterans with large portfolios.

Moreover it’s a market-beater on costs.

Aside from the exceptionally low fees, InvestEngine feels like it’s been designed to make important investment decisions straightforward. The trade-off is some choice constraints, compared to other brokers.

Strengths

  • Low costs: InvestEngine’s zero commission / zero platform fee combo is awesome for DIY investors. The robo-advice / managed service is cheaper than its rivals, too.
  • Easy to use: the platform is very thoughtfully designed, and gives the impression InvestEngine is on your side.
  • Pro passive investing: the restricted choice of ETFs is good enough. The calm user environment should promote sensible investing behaviour. As opposed to exploiting your monkey brain.

Weaknesses

  • Choice constraints: it’s ETF investing only. There are few bells and whistles. For some this will be a positive. Choice overload bedevils investors, after all.
  • Limited account options: there’s no SIPP, Lifetime ISA, or Junior ISA.
  • Robo-advice complexity: the ready-made portfolios betray the over-elaboration that’s commonplace in the discretionary management industry.

InvestEngine fees

PlatformAnnual fee Fee notes Dealing: Funds Dealing: ETFsRegular investing FX chargeEntry/exit feeGood for
InvestEngine£0 DIY investing0.25% for managed portfoliosn/a £0 for fixed times dailyn/an/a£0Very low fees
Shares ISA£00.25%n/a £0n/an/a£0-
Trading£00.25%n/a £0n/an/a£0-
SIPPNo SIPPs

Note that a dash sign in the table means ‘as above’.

Minimums:

  • Investment amount: £1
  • Account balance: £100
  • Account top-up: £1

Pros and cons

InvestEngine is the Double Decker of investment platforms. Two contrasting approaches are combined in one tasty product:

  • DIY investing that’s near-free.
  • A managed portfolio service that suggests and implements investments for you. (Also known as a robo advisor.)

The DIY investment side of InvestEngine is a serious contender – if you’re happy to work within its limitations. 

You can only invest in a restricted palette of ETFs. No shares, no funds, no investment trusts. There’s talk of adding more investment types later. But for now it’s just a select range of ETFs. 

Personally I don’t see that as a problem at InvestEngine’s prices. 

Granted, there are fewer ETFs available than at brokers who charge more. 

But I could easily build a diversified portfolio from the InvestEngine range. 

Most of the big ETF names are present and correct: Vanguard, iShares, HSBC, SPDR, and so on. 

I found low-cost options available in every important asset class. (Admittedly a few of my usual go-tos were missing.) 

Trades are executed automatically. InvestEngine buys and sells ETFs between 2.30pm to 4.30pm every day. 

You put in your orders in advance. But you can’t trade at will as with most platforms. And there’s no fancy trading options like stop-loss or limit orders.  

Prices are only updated on the platform twice a day. No worries! Just Google the price of your chosen ETF instead.

You can’t invest in a SIPP, Junior ISA, or Lifetime ISA for now. But a stocks and shares ISA and general investment account come as standard. 

If any of the above is a dealbreaker for you then forget about InvestEngine. 

Certainly day traders hooked on CFDs and candlestick graphs would enjoy it about as much as swingers at evensong. 

But otherwise, such restrictions are the quid pro quo for the platform’s passive investing strengths. 

The main USP

InvestEngine’s standout feature is the pinch-me-I-must-be-dreaming lack of fees for its DIY service. 

You’ll only pay the usual ETF management fees and dealing spreads. 

There’s no platform fee or dealing commissions. Such charges typically make ETF investing expensive for small and new investors. 

You won’t get gouged by other costs either. Don’t fret about inactivity fees, cash withdrawal charges, or FX conversion costs every time you deposit some money. 

Entry and exit fees are also absent. So you can try InvestEngine without feeling locked in. 

How does it do it? Probably by reducing overheads by reining in the vast lightshow of options you get with most brokers. 

That doesn’t mean InvestEngine has reduced customer support to a chatbot streaming expletives though. On the contrary, it typically seems responsive and helpful, judging by our sweep of the online feedback. 

User experience

InvestEngine has not cut corners on the online interface or app. Both are a pleasure to use.

Design is minimalist, thoughtfully uncluttered, and very clean. 

There’s no creeping gamification. You don’t sense that the information architecture is designed to manipulate you. 

The interface feels intuitive, easy to navigate, and attractive without being overwhelming. 

Sure, the portfolio analytics are slight. If you expect lots of flashy tools and investment ‘research’ then look elsewhere. 

But what you do get is a very clever fund portfolio order facility: 

  • Tell InvestEngine what ETFs you want in your portfolio. 
  • Select your asset allocation percentages. 
  • InvestEngine then executes the necessary trades to deliver on your asset allocation. You don’t have to micro-manage them.  

Once you’re up-and-running, you can use this feature to automatically rebalance your entire portfolio to its target allocation with a click.

That’s a passive investor’s dream. 

Do robo-advisors dream of electric money?

InvestEngine presumably hopes to make bank through its managed portfolio and robo-advisor service. 

The fee is 0.25% per year, plus an estimated 0.07% in trading spreads. That’s considerably cheaper than established rivals such as Moneyfarm, Nutmeg, or Wealthify. (Albeit we’ll have to see if it lasts.)

This ready-made service works much as you’d expect. 

You answer an automated risk tolerance questionnaire. Doing so supplies your attitude to risk, financial objectives, resources, goals, and time horizon. InvestEngine takes you down its decision tree and then serves up one of its ready-made portfolios for your approval. 

Accumulators can choose the growth portfolio options. Meanwhile anyone in the decumulation zone might opt for an income portfolio.

If you don’t like InvestEngine’s initial suggestion you can play around the edges a little, retake the questionnaire, and see what else is on offer. 

But beyond that you hand over your portfolio’s management to InvestEngine

It will rebalance for you. The ETF mix you hold will occasionally be tweaked in line with changes to your investment strategy, risk tolerance, or the product range. 

Computer says why not

In my view, InvestEngine’s robo-advice approach suffers from the industry-standard flaw of over-complication. 

It offered me a growth portfolio that included 14 ETFs. Asset allocation weights were as low as 1%. There was also a dollop of investment overlap. 

Meanwhile, the income portfolio was 99% bond ETFs studded with some eye-brow raising junk bond and emerging market sovereign debt choices.

To be fair though you might run into these issues with any managed portfolio provider. They’re the price of outsourcing control. 

If you want a robo-advice service then InvestEngine is worth a look. It delivers competitive fees, product transparency, and ease of use. 

Note it’s not regulated to offer financial advice however. (See InvestEngine’s FAQs.) 

Some other robo-advisors do provide that – for a fee. 

InvestEngine review summary

All-in-all, InvestEngine impressed me. Its market niche is truly pro passive investing and keyed towards getting the big investing decisions right. 

Low to non-existent fees mean it’s definitely worth trying – assuming you don’t mind the platform’s pared down choices. Note, transfers in are cash only, not in specie.

Trustpilot review score: 4.6

InvestEngine regulation

InvestEngine is authorised and regulated by the Financial Conduct Authority – Firm Reference Number 801128.

  • Cash is held in a pooled client money account at Natwest.
  • Investments are held in a pooled nominee account lodged with Euroclear (CREST). They are segregated from InvestEngine’s company assets.

This is industry standard.

Alternatives

  • Vanguard for small investors
  • Freetrade or Lloyds Bank Share Dealing for ISAs
  • AJ Bell Youinvest for SIPPs

Don’t forget the bonus cash offer if you sign-up to InvestEngine via our link. (Capital at risk. T&Cs apply).

Like many other sites, we may be paid a small commission if you sign-up to products via affiliate links. The price you pay is not affected. Our reviews are editorially independent.

{ 52 comments }

It’s not fair! Sequence of returns risk

You never know what return the wheel of fortune will deliver each year

With the mindset of a long-term investor, you can avoid a lot of the worries that afflict the frightened hordes. But you can’t really avoid sequence of returns risk.

Oh I know you’re not scared of a stock market crash.

Nor do you pile in at the top.

You have the tough-under-fire attitude of a Vietnam veteran on his third Tour of Duty. When share prices plummet and others quiver before CNBC, you go surfing, Apocalypse Now-style.

“Is that all you’ve got?” you laugh as the market falls 10%.

The average after-inflation annual return from shares globally is 5.3% per year1.

So as long as you sit tight and don’t panic, you’ll be rewarded, right?

Well… yes. Probably.2

The sequence of returns matters

But you’d better know there’s another kind of risk to think about, and it can be a doozy.

Assuming we’re both adding or taking money out of our portfolios over different periods of time, the return you get will be different to the return I get.

This would be true even if we saw the same average 5% real return from our portfolios.

Huh?

I know – it’s counter-intuitive.

It also has a clumsy name: sequence of returns risk.

Sequence of returns risk is the risk that fate will deal you a shocking hand. That the timing of bear markets and bull markets will fall worse for you than for another investor.

This danger is especially high when you’re taking money out of a portfolio during a market crash.

It’s why we’re urged to reduce our exposure to the riskiest assets as we approach retirement age.

Young versus old

Stock market falls are great news for young investors who invest more throughout the turmoil.

The best time to get a bad hand from the market is when you’re starting out as a saver.

You’ve got less money to lose in a market crash. Better yet, what you buy with new money at a lowered cost basis will grow in the good times to come. (Plus you get used to volatility early.)

In contrast, the last thing you should want the day before you retire is to have all your money in shares, only for the market to plummet.

You’re retired. You need that shrinking portfolio to live on.

How to multiply your money

You might not think it matters how the market tosses up its treats and its treacheries.

Returns from investment are multiplicative, after all. You multiply your money!

And every precocious child knows that it doesn’t matter what order you multiply numbers together. You still get the same result.

For example:

1 x 2 x 3 x 4 = 24

4 x 3 x 2 x 1 = 24

3 x 4 x 1 x 2 = 24

It’s exactly the same with investing.

When the market delivers a 20% return, it goes up 1.2 times.

When the market falls 10%, you multiply it by 0.9 times.

1.2 x 0.9 = 1.08

0.9 x 1.2 = 1.08

Okay, so why does it matter to us poor strivers exactly when the sturm und drang of a stock market crash hits us?

Well it wouldn’t if you were a member of the landed aristocracy and you were simply managing a big pile of loot before passing it onto the next generation.

But most of us are saving and investing over our lives to ensure our financial futures. We’ll have to withdraw money from our savings in retirement for spending.

And it’s because we add and subtract money from the market over time – at different times – that the sequence of returns risk can have its wicked way with us.

Here’s one we did earlier

Let’s consider a real world example.

Here are the total returns from the FTSE 100 for the five years from 2008 to 2012:

Year Return
2008 -28.3%
2009 27.3%
2010 12.6%
2011 -2.2%
2012 10.0%

Source: FTSE

Do the sums and you’ll see that’s an average annual return of 3.9% per year.

Now let’s imagine you invested £100 at the start of 2008. Here’s where your money would have stood at the end of each year:

 Year Return Investment
2008 -28.3% £71.70
2009 27.3% £91.27
2010 12.6% £102.77
2011 -2.2% £100.51
2012 10.0% £110.56

Note: £100 compounded for five years, as per the returns listed.

The first thing to note is you’ve ended up with less than you might have expected.

If you plug 3.9% into a compound interest calculator, it will spit out £121. You got £10 less.

Why? Because investment returns are geometric, rather than arithmetic. But that’s for another article…

For now remember we ended up with £110.56 after this five year run.

Investing in Bizarro World

Back to the sequence of returns risk. Let’s imagine you fell through a wormhole and ended up in an alternative reality, five years in the past.

(Stay with me here.)

Being a good Monevator reader, you shrug off your trip through time and space and head to the nearest stockbroker. People always need to save and invest for their retirement, even in Bizarro World.

But things aren’t entirely the same here.

In this alternative reality, the order of the annual returns from 2008 to 2012 are reversed:

Year Return
2008 10%
2009 -2.2%
2010 12.6%
2011 27.3%
2012 -28.3%

Source: Bizarro World Bank Headquarters broom closet.

This time the big crash comes at the end of the five year sequence. Rather than at the start as it did in our reality.

Do the maths and you’ll see the Bizarro World market averaged the same 3.9% return.

But what about a £100 investment?

Year Return Investment
2008 10.0% £110.00
2009 -2.2% £107.58
2010 12.6% £121.14
2011 27.3% £154.20
2012 -28.3% £110.56

Note: £100 compounded for five years on Bizarro World.

Because returns are multiplicative, we end up with exactly the same £110.56 in Bizarro World as we got on Planet Earth.

That was true even though the sequence of returns was reversed.

We expected that. So far so good.

Now add sequence of returns risk

The complication comes if you are saving or taking money from your investment over the years.

Let’s say you add £20 at the end of each year to your portfolio.

The result in our reality on Planet Earth:

Year Return Investment
2008 -28.3% £91.70
2009 27.3% £136.73
2010 12.6% £173.96
2011 -2.2% £190.14
2012 10.0% £229.15

Note: £100 initially invested, then £20 added at the end of each year.

What about in the alternate reality, where the sequence of returns was reversed?

Here you got a different result:

Year Return Investment
2008 10.0% £130.00
2009 -2.2% £147.14
2010 12.6% £185.68
2011 27.3% £256.37
2012 -28.3% £203.82

Note: Again, £100 in, then £20 added each year. Alternative return sequence.

As you can see, you’re left with a different sum. Falling through the trouser leg of time3 and investing in Bizarro World reduced your final total by around 10%.

Now I don’t know how much things cost on Bizarro World. But I’m sure anyone would rather have that extra spending money.

More seriously, this is exactly what happens in real-life to different investors with different saving and withdrawing schedules.

The sequence of returns varies over time. And so two regular savers with the same general strategy but investing over different periods will see different sums accumulated by the end.

Even if they enjoyed the same average annual return.

People who retired in the mid-1990s as the stock market soared were laughing.

People who retired in 2001 in the midst of a severe market decline?

Not so much.

The science bit: As well as the multiplication, we now have addition in our sums. So the order now matters.

Withdrawal symptoms

As I mentioned – and more scarily – all this is equally true when you’re withdrawing money as when you’re saving.

I say ‘more scarily’ because there’s not much you can do about it once you’ve stopped earning.

At least if you see a bear market while you’re accumulating money, you can try to find more cash to invest before you retire. You might even enjoy a market rebound on that extra cash you put in.

Once you’re retired though, you’ve no new money. So maybe you’ll have to spend less and cancel your subscription to Caravan Monthly.

Withdrawal method

Imagine you had £100,000 in 2008.

For the sake of this example let’s say you put it all in the stock market.

You withdraw £4,000 a year.

In the table that follows the third column shows how £100,000 would fare if you kept all your money invested. The fourth column shows the impact of withdrawing £4,000 at the end of each year:

Year Return Hands off With withdrawal
2008 -28.3% £71,700 £67,700
2009 27.3% £91,274 £82,182
2010 12.6% £102,775 £88,537
2011 -2.2% £100,514 £82,589
2012 10.0% £110,564 £86,848

Note: £100,000 in with no withdrawals, versus £4,000 taken out each year.

No great surprise. Taking £4,000 out a year reduces how much money you’re left with, compared to keeping it all invested.

But let’s now turn our telescope to Bizarro World. How does the alternative sequence of returns play out with the same £4,000 withdrawal rate?

Year Return Hands off With withdrawal
2008 10.0% £110,000 £106,000
2009 -2.2% £107,580 £99,668
2010 12.6% £121,135 £108,226
2011 27.3% £154,205 £133,771
2012 -28.3% £110,564 £91,914

Note: Alternate sequence for retirement assets on Bizarro World.

Column three reruns the £100 example. With no withdrawals, the hands-off portfolio of £100,000 compounds to the same £110,564 in both instances.

However in Bizarro World with £4,000 per year withdrawals, its sequence of returns proves more favourable for the retiree.

She ends up with £5,000 more in the pot in 2012 than her spirit sister here on Planet Earth.

Hard luck

Interestingly, the result for the retiree on Bizarro World is the opposite of what we saw with its regular savers. Savers did worse there over the same five-year period than we did.

But let’s not get hung up on these specific numbers.

The point is that sequence of returns makes a difference to how your retirement plays out. But we cannot know what returns we’ll get in advance.

Which makes it an especially thorny problem.

Don’t risk doing badly

Can you do anything to sidestep the sequence of returns risk?

Not a lot. Its impact is mainly down to luck.

You might try to guess if various markets are cheap or expensive. You could try to shift your investments accordingly.

But many people – probably most – will do worse using such active strategies than if they had just saved and rebalanced automatically.

I think the main response to sequence of returns risk should be:

  • To de-risk your portfolio by rebalancing towards safer assets as you approach retirement

All investing involves risk. But by diversifying your portfolio and playing a bit safer, you can reduce the role of luck, and increase the odds of your plan working out.

Next week we’ll consider what to do if you think sequence of returns risks is about to savage your retirement. Subscribe to make sure you see it!

  1. Source: Credit Suisse Global Yearbook 2022 []
  2. A handful of markets, such as pre-communist Russia, have been completely wiped out. Never put all your eggs in one basket. []
  3. Apologies to the late Terry Pratchett. []
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