You know the old adage about slow and steady winning the race. In the stock market, it’s known as a buy and hold strategy. Investing for retirement is a marathon — not a sprint.
Let’s take a look at the veracity of that wisdom. To do that, we’ll need to first add another type of risk to your vocabulary. This one is called “sequence of returns” risk. Have you heard of it? It’s not discussed as much as geopolitical risk, interest rate risk, longevity risk and others. To understand this type of risk, you need to know that it’s not just your “average rate of return” that’s important. It’s how and when you make those returns.
Sequence of returns risk is the risk of earning lower, or even negative, returns early in an investment period when withdrawals are made. The order or the sequence of investment returns is a big concern for retirees who intend to live off investment income.
When retirees begin withdrawing money from their investments, the returns during the first few years are crucial. What seemed like enough money could turn into less than you need if you don’t monitor those returns and reallocate when necessary.
Two retirees with identical wealth can have entirely different financial outcomes, depending on when they retire. A retiree starting out at the bottom of a bear market will have better investing success in retirement than another starting out at a market peak, even if the long-term averages are the same. The reason: Low returns at the beginning of the period hurt your value more than low returns towards the end of the period.When you’re making more than you’re withdrawing, your portfolio value is increasing. If this happens at the beginning of retirement, it allows for more growth due to the compounding of interest. By contrast, if you are withdrawing more than you’re making, you are eating into principle and your portfolio won’t compound as much. The earlier this happens, the more money you will lose.
Let’s look at two investors. Alan and Bob, recent retirees, both invest $1 million for 10 years. They both average the same overall rate of return. Both earn 6 percent for the same period of time. They also both take out the exact same amount of money each year: $45,000.
Both Alan and Bob are sticking to the slow and steady advice. They bought and held. Are they both left with the same amount of money at the end of 10 years? Probably not.
Alan was left with $796,116. Bob, however, had $ 1,397,321, even though he averaged the exact same 6 percent over 10 years. Why? Bob had positive returns early in his withdrawal cycle, while Alan lost money in the very beginning of the withdrawal cycle.
The more the returns are varied, the more the sequence matters.If you lose 30 percent, 16 percent and 15 percent in the first 3 years and then make 20 percent each year for the next seven years, your compound average return over the 10-year period is roughly 6 percent. Not bad, right? Wrong. Your portfolio will be worth $200,000 less than when you started (10 years prior). In contrast, you end up with $200,000 more than you start with if you are able to earn a steady 6 percent return each year.
To reduce your risk of winding up like Alan, you must maintain steady, less volatile returns early in retirement. You can accomplish this through the virtues of diversification, and the bucket approach I have written about here. (You need “buckets” for cash, income and growth.)
Slow and steady is still good advice. But like most things in life, there’s often “more to the story”.