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Explaining Sequence of Return Risk and Possible Solutions

There are some risk considerations that we should be aware of when we are spending down our assets. The majority of the folks are at a stage where they focus on wealth accumulation, but, what I realize is that the considerations when you reach the stage of withdrawing part of your wealth from your wealth assets are very different.

Due to the failure to understand this, it may cause serious impact into your retirement or financial independence plan. In this article, we try to define what is sequence of return risk and its impact to your plan or considerations that you need to put in place due to this risk.

Generic spending considerations for your wealth fund

Most would see their wealth objectives to meet a particular spending goals in the future when they stop working. We can call this stage retirement or financial independence.  You spend a large part of your time when your human capital is productive to earn wages and you prudently build up wealth so that you can retire.

When it comes time to spend it there are much considerations. How much do you need annually and how would inflation affect your purchasing power. How do you make sure you do not out live your assets that provides the annual spending cash flow.

On the part of the wealth fund, there are considerations such as how much you have build up, how safe you want the cash flow  during retirement to be versus a higher spending % with the risk that your assets will run out. The size of your fund will also determine the assets and instruments you use to meet your spending needs.

If you have $5 mil build up and require $40,000 over 30 years, you do not need to take above average risk to the type of assets you use, but, if you have $500,000 build up and need $25,000 over 30 years,  your assets will not last you unless it grows during these 30 years when you need to spend them down.

This would usually entail a paper portfolio of stocks and bonds with a particular asset allocation mix (e.g. 50% stocks, 50% bonds). You need to consider controlling the volatility versus the rate of return necessary to ensure you meet your minimum spending floor.

Geometric Returns without Withdrawing Cash Flow

When you have part of your assets in stocks, you have to contend with volatility.

When you are building up your wealth fund, these volatility is acceptable because you have a longer term horizon for the volatility to work itself out and hopefully, resolve on an upward bias trajectory.

In terms of the geometric sequence of returns, they don’t matter that much.

Consider that A and B have $1 at the start. For the next 5 years A’s geometric return profile is as follows:

  1. +10%
  2. +30%
  3. -50%
  4. +40%
  5. +5%

B’s geometric return profile is as follows:

  1. -50%
  2. +10%
  3. +5%
  4. +30%
  5. +40%

A’s $1 at the end of the 5 years is: $1 x 1.1 x 1.3 x 0.5 x 1.4 x 1.05 = $1.051

B’s $1 at the end of the 5 years is: $1 x 0.5 x 1.1 x 1.05 x 1.3 x 1.4 = $1.051

Different rate of return profile but they end up at the same place.

Geometric Returns when you Withdraw Cash Flow

The following illustration give an example of geometric returns but this time with withdrawal

The key difference here is that the systematic withdrawal deprives the fund from having the same amount of assets to comeback after the initial bad years. This becomes escalated if, the person needs to keep up with inflation and embeds an escalating 2-3% more withdrawal per year. Here is another example

The interesting thing is that in both examples, it takes only 3 years of consecutive less than 30% down years to wreck havoc. We know that you can have another 2000-2002 serious bear market that illustrate the same situation.

The impact

It would seem a very big determinant of whether you have enough wealth assets to last the duration you require depends very much on the first few years not being bad.

  • An early secular bear (a market cycle that lasts for 20 years)  at the start of your retirement or financial independence follow by a late secular bull is a big problem as illustrated
  • An early secular bull market follow by a late bear is not a big problem as your assets would have appreciated adequately to buffer for the future bear
  • A secular bear that lasts the entire 30 year duration of your retirement or financial independence will be shitty no matter how you look at it
  • A secular bull that lasts the entire 30 year duration of your retirement or financial independence is a really good situation to have

With that in mind what are some of the solutions we can explore?

De-risking your portfolio briefly

The above illustrations show a wealth fund made up of 100% allocation to stocks. Averting the first 5 years of any drawdown that cannot be foreseen can be a solution.

Shifting to a 20% equity, 80% bonds or 60% bonds, 20% cash allocation for a short duration could avert this problem.

You can then after 5 years systematically scale up the equity portion so that to ensure your assets grow to keep up with inflation.

My concern here is that, how long the draw down will last. A secular bear will have numerous ups and downs. Adverting the first 5 years might mean you adverted a bull run in a secular bear only to be ready to scale into the bear leg of a secular bear.

De-risking your portfolio with safety first strategies

Similar to the first solution, but instead of a brief shift to lower volatility instruments, do it on a more permanent basis. By reducing the risk profile, it is a more safety first approach. You are ensuring that you have a high degree of how much $ you can get and how long it lasts.

Assets that fell into this category are:

  • Bond ladders
  • Annuities
  • Bond ETFs or Funds

The downside of de-risking is that, if you have ample amount of wealth build up with excesses, this strategy ensures you meet the spending goals. But, if you are flirting with a wealth that may not have that much excesses, de-risking may result in your wealth fund not growing as well to keep up with inflation, since a small % of your $ has the potential to high growth.

This may entail your wealth fund not lasting for the lifespan you require to spend.

A variation of this is that, since majority of your annual spending cash flow withdrawal are taken out from these lower volatility assets, increase the risk of the stocks allocation (15%?) by using leverage ETFs to boost the returns.

Have the following spending workflow:

  1. If stocks allocation exceeds the 15% allocation, sell the equity allocation and use the returns to boost the spending cash flow
  2. If the stocks allocation does not exceed do nothing (or perhaps we should rebalance into it?)

This approach creates spending increase, and spending will never decrease. Rebalancing into the leverage ETF is risky as that allocation can be wiped out. The person is only exposed to 15% high volatility while 85% of the allocation creates predictable spending.

Income based asset approach

One approach to prevent the principal to be withdrawn that creates the sequence of return risk problem is to focus on income producing assets. These would include

By spending only the income distributed, the principal has the potential too grow after the initial loss of value.

The weak point of this approach is that, your annual withdrawal spending depends very much on the yield afforded by the property rental, dividend stocks.

The assumption for wealth distribution is that, there is a particular spending goal that you need to meet. And when you don’t meet it, its considered a failure.

Property might not be rented out or rented at reduced lease and when the markets are not doing so well, dividend distribution can get cut.

You protect your principal amount here but your ability to fulfil your spending floor is compromised.

Cash Flow Reserve Ladder / Bucket Approach

The idea behind this plan is to create steps based on how far out you need the money. Specifically, to combat the sequence of return risk, a 1 to 2 year liquid non volatile cash reserve is built up which caters for the first 2 years spending needs.

This ensures that the volatile stocks portion do not get withdrawn and they have the potential to swing back up when the stock market becomes better.

 

In this illustration,  the cash flow distributions such as  dividends and interest income are channel to the cash flow reserves which will then be in waiting to be spend in the next 1-2 years. Suppose your stocks do not have high dividends, a rule can be set such that:

  1. Periodic rebalancing between fixed income bonds and equity stocks investments. Its a systematic buy low sell high
  2. If equity stocks investments are positive and doing well, sell part of equity stocks investments needed for annual withdrawal cash flow and move it to cash flow reserve.
  3. If equity stocks investments are negative, move the bonds portion

The result is minimize the drawdown when equity markets are not doing so well.

In some cases the buckets or assets are match close to the spending horizon, and they are executed more stringent. the worry here is that rebalancing between asset classes cannot take place and the person misses out on the performance and systematic prudence afforded by rebalancing.

This approach looks very much to be a combination of the few approaches before and you can see the elegance in this solution.

Variable Spending Strategies

The assumption here in this article is that the person have a fixed spending goal and if you do no meet this then its a failure. In reality,  people may not spend like that. They tighten up when things get challenging and tend to spend more when the situation is good.

The idea here is to come up with a fixed set of ‘scripts’ to control a person’s withdrawal depending on the economic situations, the initial withdrawal amount, the withdrawal percentages.

The original idea of this strategy is to boost the hard 4% withdrawal rate identified by William Bengen in Oct 1994 of a safe withdrawal rate based on historical USA figures that will last a person over a long time, such that they will not outlive their asset.

In recent years this rule have been challenged due to the change in economic climate and the corresponding investment returns.

These variable spending strategies serves to boost to a greater than 4% withdrawal rate to improve spending, but it helps sequence of return risk because many of what was simulated would include negative sequences.

David Zolt have a good article here on retirement planning by targeting safe withdrawal rates.

Some rules:

  • If stock markets return is good, annual spending withdrawal goes up with inflation (CPI). If stock markets return is bad, no increase in annual spending withdrawal
  • If current annual spending withdrawal is less than 1st year annual spending withdrawal, the no increase in withdrawal rule does not apply (if not you get to spend less than what you original plan out)
  • Capital preservation rule: If current annual spending withdrawal RATE is greater than 120% of 1st year annual spending withdrawal RATE, reduce current annual spending withdrawal by 10% ( your portfolio is shrinking)
  • Prosperity rule: If current annual spending withdrawal RATE is less than 80% of 1st year annual spending withdrawal RATE, increase current annual spending withdrawal by 10% (your portfolio is growing)
  • Portfolio Management rule: Make priority withdrawal from asset classes which experienced the greatest growth

The idea here is to create fundamentally sound wealth management decision rules to ensure that spending is not increase when markets are bad, with the occasional recalibration back to original spending withdrawal amount.

The risk here is that the plan needs to be well thought out, failure which could leave the person in a worse off position.

By accepting this, you may be subjected to losses in purchasing power, while boosting your annual withdrawal RATE.

This fits for a person who are very well aware of how he wants to spend his money, spends the time to understand how his plan works, and points of failure. He must also be someone willing to execute such intermediate wealth management rules.

Most importantly, it fits for the early retirement or financial independent folks (a bit ironic here) who is planning with little buffer and working with tight wealth fund parameters (e.g 6% withdrawal on a $400,000 all stock wealth fund)

Multiple streams

The last solution are alternatives, where a person not just have his wealth fund to depend upon but also government social security support, children support or strong enough to still work on a part time basis.

An understanding of sequence of return risk will enable the person to be stringent about spending less than the spending goal and make up via these other sources.

Summary

Sequence of return risk can be called the evil step brother of dollar cost averaging or reverse dollar cost averaging  and could pose some complications to your retirement goals.

If you digest this whole article, you will realize that a common theme is that even the solutions have much negative aspects that you would need to find more solutions to.

This is why having a competent planner really can bridge the knowledge gap and hopefully guide you well so that you do not outlive your assets.

There isn’t a foolproof solution. Well there is, that is build up $5 million and spend only $50k annually.  This gives you much more buffer or margin of safety to work with.

To figure out how much you need to be financially independent or retire, you have to work to figure out some basic parameters such as your ideal must have and good to have expenses as well as how you can still competently build wealth when you get that. If you have not figured out do find the resources that can help you figure out.

One big lesson to learn for me on putting eggs in one basket from GTAT Case Study
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