Imagine you have an investment account that enjoyed a 12% gain two years ago, a 4% gain last year, and a 10% loss this year (if the year were already over). Now imagine that you have another investment account that suffered a 10% loss two years ago then enjoyed a 4% gain last year and a 12% gain this year. Assuming no deposits or withdrawals were made, which account performed better?
That’s right: it’s a trick question. The two accounts ended the same! In fact, we could have arranged those hypothetical returns in any order, and the result would be the same as long as there were no inflows or outflows during those years.
This concept called Sequence of Returns was non-intuitive to me before I was in this profession. I would have expected that the later years’ returns matter more because they’re more recent. Other folks might have thought that the early years’ returns matter more because they impact the account sooner.
However, both of these assumptions are wrong if we’re talking about buy-and-hold investing and stripping out cash flows. The reason is mathematical. The sequence of returns doesn’t matter because A × B is the same as B × A.
An important note: in cases where deposits and withdrawals are being made – which is many clients’ accounts in the real world – the sequence of returns does matter! Even if two investors experience the same average annual return, the timing of the good and bad years matters to their unique outcomes. After all, it is preferable to “buy low and sell high” when inflows and outflows are occurring. The compounding effects play into both the accumulation phase and distribution phase of a financial lifecycle.
The Sequence of Returns Effect
|No Cash Flows During the Timeframe||Accumulation Phase (Example: Depositing and making investments in an account)||Distribution Phase (Example: Selling investments and withdrawing from an account)|
Better returns earlier, worse returns later
Worse returns earlier, better returns later
|Better returns earlier, worse returns later||Not preferable||Better returns earlier, worse returns later||Preferable|
|Worse returns earlier, better returns later||Preferable||Worse returns earlier, better returns later||Not preferable|
In Focus: The Accumulation Phase
When an investor is contributing into their account, it would be to their advantage to experience the worse returns in early years and the better returns in later years. This is because the account balance would be smaller when subject to losses. The positive years would compound a larger balance towards the end.
In Focus: The Distribution Phase
The distribution phase is functionally the most important to most people. We don’t want to experience a bear market in the early years of retirement. All else being equal, the early years of retirement are the most crucial to a retirement portfolio. Early market losses could strain the distant years’ spending goals because the account has a double-whammy of cash outflows and investment losses.
Financial advisors like us take steps to mitigate this timing risk. A common approach is to allocate a bucket of cash or conservative assets in the portfolio to accommodate a few years of spending needs. By doing so, we lower the chance that we’d need to sell longer-term investments like stocks during a market turndown. It allows that piece of the pie to be held until the market recovers.
Other solutions for soon-to-be or recent retirees to consider are to retire slowly and to adopt a flexible withdrawal strategy. Moving from full-time work to part-time work, even if it’s in a different field, helps many folks make the lifestyle shift. It allows them to not only retain a sense of purpose but also smooths the financial transition. Meanwhile, flexible budgeting (as opposed to having rigid account withdrawals) can prolong retirement success by adapting to the variability of market returns.
“Rearrange Time” to Feel Better
During a dreary year in the stock market, I believe the Sequence of Returns concept is a good reminder to long-term investors. It helps us to confront recency bias. Recency bias is a cognitive bias that causes us to put too much emphasis on recent events or data. It can lead people to make decisions that deviate from their long-term plans.
It is easy to focus on this year’s disappointing stock market because we are suffering through it at this very moment. However, unless notable deposits or withdrawals are being made in your account, we essentially could have swapped this year’s puny performance with last year’s excellent performance. Imagine having been disappointed last year and elated this year. What would that feel like?
It may sound strange, but this algebraic fact gives me a glimmer of confidence as a long-term investor. I hope it gives some comfort to you too.