Ask any advisor what principle they have to explain the most, and many will tell you its average returns vs. sequence of returns.
That’s because most of us plan for the future based on what we know using data from the past.
Whether it’s the average temperature in June, or the average cost of your water bill…an average is an educated guess using cumulative data, right?
People also rely on this cumulative data with investing to make educated “guesses” about their expected returns.
Usually, people have a spreadsheet with a modest 5% or 6% expected rate of return. As the rows and years go on, the money never runs out.
I bet every advisor is nodding their heads right now. They know what I’m about to say.
Outcomes for average returns vs. sequence of returns are wildly different. The reality of investing forces us to use a sequence of returns - factual cumulative data - to make a fair hypothesis about any portfolio’s future. Add taking retirement income to the equation and the difference greatly widens between the outcomes from average returns vs. sequence of returns.
The cons of relying on average returns for retirement planning are significant.
First, as the article’s title suggests, averaging doesn't take into account the sequence in which the returns are earned (or lost).
Second, while it provides a measure of an investment's performance, it doesn't tell you anything about the distribution of those returns. Two investments could have the same average return, but one could have more significant volatility than the other, leading to significant losses in the short-term.
To explain average returns vs. sequence of returns, I use “The Tale of Two Brothers”.
Consider two brothers aged four years apart. They have identical portfolios: $1 Million in retirement savings. They have experienced the same market conditions in their saving years.
The only difference is that the older brother retires four years earlier than the younger brother.
Unfortunately for the older one, the market drops 10% the year he retires. Does anyone think he had -10% on his spreadsheet? Especially in the first year?
Between his cost of living and loss in the portfolio, he’s in bad shape. One more year of negative returns, and his million will be potentially gone within a decade.
Understanding the Importance of Sequence of Returns
The pros of focusing on sequence of returns is that it can have a significant impact on the sustainability of your retirement portfolio.
The order of returns in the early years of retirement will have a much greater impact on the longevity of your portfolio than people typically consider.
Remember that while average returns can give you a simple view of your investment performance, they don't tell the whole story. Often, they lead us to believe we’re in better shape than we are.
In contrast, sequence of returns takes into account the realistic ups and downs of the market. If you’ve always used averages to anticipate your retirement income, the best way to get a more accurate picture is to work with an advisor.
Finally, I recommend holding assets in your portfolio that are not negatively impacted by poor market performance, in addition to your retirement account(s). Those types of Buffer Assets can be utilized when the market is down, so you don’t touch the retirement account while it recovers.
If you’d like to learn more about buffer assets, feel free to contact us. You can always email me directly at jeff@enhancedfunding.com or call 773-318-9608.