The Sequence of Returns: Why Timing Matters

In investing, it’s not just what returns you achieve, but when you achieve them that significantly impacts your overall wealth. This is the concept known as the sequence of returns risk.

Imagine two hypothetical investors, Alex and Ben, each investing $10,000 annually for 30 years. Both achieve an average annual return of 7%. However, Alex experiences high returns early in the investment period, followed by lower or even negative returns later. Ben, conversely, experiences lower returns initially but enjoys higher returns towards the end.

Despite the identical average return, Alex will likely accumulate significantly more wealth than Ben. This is because early gains, compounded over time, generate a larger base for future growth. Higher returns early on act like a snowball rolling down a hill, accumulating momentum and mass as it progresses.

The impact of sequence of returns is especially pronounced during the accumulation phase, but it becomes even more critical during the withdrawal phase, such as in retirement. If an individual experiences negative returns early in retirement, they are forced to withdraw a larger percentage of their remaining assets to cover living expenses. This reduces the base for future growth and increases the risk of depleting their savings prematurely.

Several strategies can help mitigate sequence of returns risk. Diversification across asset classes is crucial, as different asset classes perform differently in varying market conditions. This helps smooth out the return stream. Dollar-cost averaging, investing a fixed amount regularly regardless of market fluctuations, can also help by reducing the risk of investing a large sum right before a market downturn.

For those in the withdrawal phase, adjusting spending habits based on market performance can be beneficial. Reducing withdrawals during down years allows the portfolio to recover. Annuities, which provide a guaranteed income stream, can also be considered as a hedge against sequence of returns risk, although they come with their own set of considerations like fees and surrender charges.

Ultimately, understanding the sequence of returns is essential for long-term investment success. While you can’t control market fluctuations, you can control your investment strategy and take steps to minimize the potential negative impact of unfavorable return sequences.