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Understanding Sequence of Return Risk

Sequence 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.
one-portfolio-risk-to-rule-them-all

Comments

  • beebee
    edited December 2020
    Attempting to sustain a fixed living standard using distributions from a portfolio of volatile assets is an inefficient retirement income strategy. This is a unique source of sequence risk.

    There are four general techniques for managing sequence of returns risk in retirement:
    the-hidden-peril-in-sequence-of-returns-risk
  • Thanks @bee, the first article in particular was very informative for me. I've wondered about sequence of return risk from a different perspective historically and that is if you bought the idea that small value outperforms in the long-term and started investing for your kids in 2009, you might even be right overall but just not if you started at a point in time where you'd give up more than 250 basis points annually over the first 12 years of your investment life.

    Does anyone have any ideas how to manage sequence of return risk for an 18 year-old?
  • @LLJB, many would point out that there is no such thing --- simply put the teen broadly and cheaply into equities and leave it alone for decades

    but are you implying the child will be needing it soon, like within a decade?
  • @davidrmoran, there's certainly no shorter-term need, I'm thinking in terms of 40 years and most likely more. My thought, though, was that some things can be out of favor for more than a decade. Based on valuations today, GMO predicts negative real returns, and not small ones, for US equities for the next 7 years. They also predict very high returns for Emerging Markets value.

    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.
  • k

    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!
  • "My take is So what? 40y??"

    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.
  • The OP spoke of an 18yo and "ways to mitigate that [7y hole based on GMO predictions] risk."

    >> 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/
  • It's unclear what risk is to be mitigated. LLJB speaks of " put[ting] your kids in equities ... and very likely have dug them[] a deep hole after 7 years."

    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:
    the fundamental point is simply this: for investors that have no cash flows coming out or going in to a portfolio [lump sum investment], it’s feasible to just wait for long-term returns to manifest. However, for retirees taking distributions, or accumulators making contributions, the cash flows moving in/out of the portfolio introduce a sequence of return risk
    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:
    the reality is that target date funds (or lifecycle funds), which typically take equity exposure off the table in the years leading up to retirement, arguably really do have it right when it comes to asset allocation for accumulators. Reducing equity exposure in the final years – as the portfolio gets largest and most sensitive to return volatility – is an excellent means to narrow down retirement date risk.
    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.
  • You shd be assisting that Duke econ prof Edward Tower, clearly.
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