The Sequence of Returns Deconstructed

2 men going over reports

What is the SOR?  Basically the sequence of returns is just that.  It is the sequence in which the returns on our investment performance occurs over time. Let’s take two portfolios – one that has the predominance of positive returns in the early years of the portfolios history and the other portfolio with the exact reverse order of the returns in the first portfolio. Now understand that if the first portfolio returns an average 6% the second portfolio will have the exact same average.  Great!  So what’s my point?

The SOQ and its impact on your retirement or investment nest egg comes into play when persons such, as retirees, start taking “distributions” out of these accounts.

Take a look at the chart below and we’ll walk through it together.

In this instance we started out with a million dollars at age 65 and remained invested until age 90.  In what is referred to as the “Up-Market” the majority of returns in this portfolio are achieved in the earlier years of the investment.  The “Down-Market” portfolio returns are just the reverse of those found in the “Up-Market”. Notice the returns of each portfolio regardless of their sequence is 6%.  The initial $1000,000 dollar investment turns into $4,288,197. 

Now let’s throw in another variable to make our point clear. Let’s take out a 5% distribution from both portfolios and see what happens.

As you can see the results are pretty alarming and without a visual it would be even harder to explain.  A 5% distribution on a million dollar portfolio is $50,000.  Easy. In the “Up” Market portfolio that has the positive returns in the early years the $50,000 has less of an impact on the resulting sum of the portfolio because we were adding value as a result of the investment performance to the account in those early years. 

The “Down” Market portfolio which suffered from early losses added to those losses with the 5% distribution.  In fact, in the first year, when the market lost 25% we need to subtract the additional 5% for distribution for a total of 30% reduction in our portfolio.  Our $1000,000 account is down to only $700,000 and we have 24 years left in our example.

In year 3 of our story the “Up” Market enjoys a 28% boost to the account minus the 5% distribution for a net of 23%.  The account is now up $230,000.  “Down” Market account is reeling from another -14% loss with another 5% distribution for a total net loss to the account of 19%.  In only 2 years we have depleted this account by almost 50%. 

A 50% loss in our investment would require the market to generate a return of almost 100% to get us back to even.  How long would it take for the market to generate a 100% return?  We have no idea.  We do know one thing for sure and that is it would take even longer if you take into account the 5% distribution our client was withdrawing.

As you run the sequence through its course we see that at age 90 “Up” Market account is flush with money to the tune of $2,517,217 while our retiree who is holding the “Down” Market portfolio has run completely out of money by age 83.  I am sure that this wasn’t the retirement plan they were counting on.

So why do we bring the “Sequence of Returns” up in the financial planning conversation in the first place?  The central point of this exercise is to highlight the fact that nobody knows when the negative returns will come in the future and how long they will last.  We all know that we have enjoyed an extended “bull” market for the last 12 years.  To believe that this will go on forever will be surrendering to the old adage of “the triumph of hope over experience.”

We do know for certain that negative returns will materially and negatively impact the lifestyle of many of our clients during their retirement years when they are taking distributions from their investment accounts.

Prudent advisors will ensure that our clients understand the risks that they take when investing and present a variety of suitable investment options that might mitigate or with certain strategies even eliminate the impact of negative returns.

Chart courtesy of Robert W. Baird & Co.

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