Today I’m going over a concept that is near and dear to my heart called sequence of return risk. It’s a fairly complicated concept, so to help me explain I’ve provided some graphics and numbers for you to follow along with in the video above.
Say there are two friends who both have $500,000 and are getting ready to retire. They don’t have any more money to add to the $500,000, so they are relying on the market to deliver returns.
Above you can see the numbers broken down over the course of 10 years for both friends. One starts off by having good years and ends with bad ones, while the other starts with bad years and ends with good ones. After the 10 years, both friends end with the same amount because whether the good or bad years come first, the average rate of return is the same. This is because the numbers themselves didn’t change, only the order.
Now, let’s say they both need to take out 4%, so $20,000 each year. The first friend who takes out $20,000 ends the 10 years with more than $500,000 because he had good returns in the beginning. On the other hand, the second friend ends with a significantly lower amount than $500,000 because he had bad returns in the beginning. They took out the same $200,000, so why does the second friend end the 10 years with a lower number?
In the beginning years, not only was the second friend getting very low returns, but he was also taking money out, which affected his ability to rebound. If you look at the end of the third year for both friends, you’ll notice that the first friend had a much greater amount because of his great returns in the beginning.
This is what the sequence of return risk is all about. If you get bad returns in the beginning of your retirement when you’re taking money out, it’s very difficult to recover from your returns in later years.That’s why it’s so important to understand your portfolio’s risk number. If your portfolio holds too much risk and you have bad returns in the first three to five years of your retirement, it could be almost impossible to recover from it if you need to continue to take money out.
If you would like to figure out your risk number, you can use the Riskalize tool on my website. You can learn all about Riskalize by checking out my previous video here.
If you have any other questions for me please feel free to give me a call or send me an email. I’m always happy to help!