Summary: Sequence of Returns Risk
From 1981 to 2020, the S&P 500 returned 11.5% per year on average. That’s a pretty nice rate of return – if you had $10,000 invested at the beginning of this period, it would have been worth about $780,000 by the end of 2020 (excluding the impact of investment fees and taxes). That’s a great statistic, but it ignores a pesky phenomenon known as sequence of returns risk.
It’s easy to reflect on this period and imagine that it was smooth sailing in the markets. All you had to do was sit back and watch your portfolio grow. However, there’s a reason why our math teachers spent time teaching us about median, mode, and standard deviation: there is much more that goes into analyzing a dataset than calculating the mean alone. Take that 40 years of strong performance for the S&P, for example. Annual returns ranged from a high of 38% in 1995 to a low of -37% in 2008. The annual return was only within 3% of the 11.5% average for the period on six different occasions. If you had all of your money invested from the beginning of this period to the end, then returns earned in each year weren’t of any consequence. But if you were relying on your investments for income, or you were investing on an ongoing basis, then performance in each individual year would have had a huge impact on your overall portfolio value.
Sequence of Returns Risk Explained
Sequence of returns risk arises from the order in which your investment returns occur. When you are withdrawing money from a portfolio to fund your lifestyle, for example, you run into this risk when you need money at a time when the market is falling. Take a simple example where a hypothetical investor named Phyllis Vance has a $1 million portfolio and requires $40,000 at the end of each year to fund lifestyle expenses (we’ll ignore the impact of taxes). Assume that the market returns 5% on average over a two year period, but this is comprised of one year with a 15% return and another with a -5% return. If the 15% return year occurred first, then Phyllis would be taking $40,000 from a portfolio worth $1,150,000 (a withdrawal equivalent to 3.5% of the portfolio), leaving $1,110,000 remaining. Since the return for the following year is -5%, when Phyllis again pulls out $40,000, she’ll be left with $1,014,500 and her withdrawal will be equivalent to 3.8% of her portfolio. Now imagine these returns happened in reverse order, and the portfolio earned -5% in year 1. Phyllis’s $40,000 withdrawal would therefore be equivalent to 4.2% of her portfolio value and leave her with $910,000. A return of 15% would then bring the portfolio up to $1,046,500, and the subsequent withdrawal would leave Phyllis with $1,006,500. The same average return and the same withdrawals, but a difference in final portfolio value of $8,000. And this is after only a two year period – sequence of returns risk is magnified for longer time periods and larger variance from the mean.
The same risk also exists for investors who are actively contributing money to their portfolios. If the market experiences its best growth when you are just starting to invest and returns lag later on when you have had more time to save money to invest, then your ending portfolio value will suffer as a result. Take another simplistic example where a hypothetical investor named Jack invests $10,000 at the beginning of each year for 10 years with an average return for the period of 5%. However, this average results from 5 consecutive years of 0% growth and 5 years of 10% growth. If the 0% growth years happen first, then Jack’s portfolio will be worth $147,681 at the end of the 10 year period. If instead the 5 years of 10% growth had occurred first, Jack’s portfolio would be worth only $133,261. The average lied to Jack, and it cost him over $14,000.
What Should I do About This?
Investors instinctively want to know how much an investment has returned on average. This is even supported from a regulatory standpoint: fund managers must disclose average annual returns in their fund facts documents. However, we’ve indicated that average returns don’t tell the whole story. Investors need to when they will need access to their money in order to determine which returns metrics are relevant in building an investment portfolio. Factors such as maximum drawdown will be important for those who need immediate income from a portfolio, while standard deviation (which calculates how far individual returns deviate from the average) should factor in for individuals who are actively saving and investing. Beyond this, be sure to build in a margin of safety when investing or when making withdrawals from your portfolio. Don’t assume that you will be saved by an average market return of 11.5%. Returns sequencing may work out in your favour, but when dealing with an uncertain future it is always better to plan for the worst and hope for the best.
If you are going to meet up with two guys who you are told are 5’10” on average, you’d be pretty surprised to be greeted by Shaquille O’Neal and Danny DeVito. The average is useful when dealing with distributions that follow a normal distribution, where most individual data points are clustered pretty close to the mean. This is not the case with the stock market, where the average is comprised of a bunch of Shaq’s and DeVito’s. If you want to ensure a better than average outcome, look beyond the average when making investment decisions.
Opinions are those of the author and may not reflect those of BMO Private Investment Counsel Inc., and are not intended to provide investment, tax, accounting or legal advice. The information and opinions contained herein have been compiled from sources believed reliable but no representation or warranty, express or implied, is made as to their accuracy or completeness and neither the author nor BMO Private Investment Counsel Inc. shall be liable for any errors, omissions or delays in content, or for any actions taken in reliance. BMO Private Investment Counsel Inc. is a wholly-owned subsidiary of Bank of Montreal.