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one-portfolio-risk-to-rule-them-allSequence risk is the risk that investment returns happen in an unlucky order. It can make or break portfolios and this post shows how to protect against it.
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Does anyone have any ideas how to manage sequence of return risk for an 18 year-old?
but are you implying the child will be needing it soon, like within a decade?
If they're right and you just put your kids in equities, passively, even in a Total World fund, they will very likely have dug themselves a deep hole after 7 years simply because they got unlucky with sequence of return risk. It's like the case in Bee's article that shows the difference in eventual returns depending on whether the big negative is at the beginning, middle or end of the time period.
If there are ways to mitigate that risk and increase the likelihood of a better outcome then it'd be interesting to think about the options.
My take is So what? 40y?? I would not even do Total (Schwab is best). I would do VONE and call it a day. Or with a third into QQQ.
7y meh returns, feh. Prediction? Who cares? For 40y, forget EM and foreign.
If however you can indeed tell the future, let us know; I wanna join!
It sounds like you are thinking about a single 40 year investment. Of course if we invest money in something with an average return of X% over 40 years, it doesn't matter what the sequence of returns is. We wind up with (1 + X%) ^ 40 times the original investment regardless of how the annual returns are sequenced.
In the real world, workers invest money periodically over their careers. Sequence of return matters.
One way of thinking of the accumulation phase is as a decumulation phase in reverse. Run time backwards from point of retirement to point of hire. Instead of adding money periodically, as time goes backward you're withdrawing money periodically. (I have this mental image of someone walking backward out of a brokerage with a check in hand.)
If you have good years shortly before retirement (or shortly "after" retirement as time rolls backward), you do better. What "better" means here is that your pot at the point of retirement is larger. If you have bad years near retirement, you do worse.
This makes sense because the closer you are to retirement, the larger the portfolio and the more a bad year will hurt. This is the idea in using glide paths prior to retirement.
>> If there are ways to mitigate that risk and increase the likelihood of a better outcome then it'd be interesting to think about the options.
So what would concrete advice be? DCA? Delay starting now because valuations? Some sort of reverse glide path?
>> In the real world, workers invest money periodically over their careers. Sequence of return matters.
How do we know how and when to do act?
If people are proposing that GMO predictions are truly useful, everyone had better start paying attention to them.
Here's a paper concluding they are indeed prescient. It's from 12y and 1mo ago, middle of November '08.
http://public.econ.duke.edu/Papers//PDF/GMO_Predictions1.pdf
Of course here's the end of Q1:
https://www.gmo.com/americas/research-library/gmo-7-year-asset-class-forecast-1q-2020/
LLJB then goes on to put this in the context of sequence of return risk: "because they got unlucky with sequence of return risk." By definition, sequence of return risk assumes that you do not have insight into the sequence of returns.
Are we talking about sequence of return risk, where one does not know or have reliable guidance into the order of returns and where one may be lucky or unlucky, or are we talking about working with reliable guidance?
Given that this thread is about sequence of return risk, that this risk was specifically mentioned by LLJB, and that the article LLJB cited explicitly described accumulation phase sequence of return risk, I took "risk" to mean sequence of return risk. In that context, the unlucky sequence of returns that GMO predicted is merely one of many possible outcomes. One that will be realized "If they're right ...", but one with no greater likelihood than any other sequence of returns.
As I wrote before, if we're talking about a lump sum investment, there is no sequence of return risk. But there is in the accumulation phase if money is being added periodically. Here's a piece by Kitces on sequence of return risk in the accumulation phase.
https://www.kitces.com/blog/retirement-date-risk-how-sequence-of-returns-risk-impacts-a-pre-retirement-accumulator/
He writes: Emphasis in original.
I also implied that accumulation phase glide paths are designed to mitigate the impact of poor returns when your portfolio is larger, i.e. to mitigate sequence of return risks. Kitces concurs: OTOH, should one assume "that GMO predictions are truly useful" then we're out of the realm of sequence of return risk and into market timing. Perhaps slow motion timing (seven years), but timing nevertheless.