When Sequence of Returns Matter

We all want to maximize returns but the strategy that maximizes returns in one scenario may fail completely in another.  For example, on average, the stock market outperforms bonds, and on average the cost of debt is lower than the return on stocks.  Someone trying to maximize returns in this average scenario would be 100% invested in equities and would buy additional shares on margin to additionally leverage up performance. 

But like the six-foot man that drowned crossing a river with an average depth of four feet, averages often hide important risks.

Take Rick Guerin as an example. 

Warren Buffett and Charlie Munger used to have a third investing partner named Rick Guerin.  In the early years, the three men invested in all the same deals.  Until one day, that stopped.  When asked what happened to Rick, Warren Buffett said,

“Charlie and I always knew that (we) would become incredibly wealthy...we were not in a hurry to get wealthy; we knew it would happen. Rick was just as smart as us, but he was in a hurry. And so actually what happened – some of this is public – was that in the ‘73, ‘74 downturn, Rick was levered with margin loans. And the stock market went down almost 70% in those two years, and so he got margin calls out the yin-yang, and he sold his Berkshire [Hathaway] stock to me. I bought Rick’s Berkshire stock at under $40 apiece, and so Rick was forced to sell shares at … $40 a piece because he was levered.”

The same shares he sold for $40 ended up having great average returns and are now worth roughly $700,000 each. But none of that matters since Rick was forced to sell his shares when they were down and was never able to enjoy the recovery. 

Something similar can happen to retirees that fail to consider sequence of returns once they begin distributions.   

Take these two charts from Blackrock as examples.

When accumulating, the order of gains and losses does not actually impact the portfolio (assuming there are no additions or withdrawals). Each line above shows the portfolio value over time of three different hypothetical investments which all had an average annual rate of return of 7%. All three investments ended with the same value, although they experienced different paths to get there.

However, once an investor begins withdrawing from the portfolio, the story changes.

Withdrawals, like leverage, compound losses, making it harder to recover from a decline, especially one that comes early in the sequence. The examples above illustrate the value over time of the same three portfolios from the first chart, but we’ve now added $60,000 inflation-adjusted annual withdrawals.

All portfolios experienced the same average return, but in the scenario with early losses, the retiree ran out of money.

Fortunately for retirees, this is a risk that is easily managed by having sufficient emergency reserves such that an investor is never forced to sell things when they are down. The problem, of course, is that emergency reserves tend to reduce average returns.  

In the same way that Buffett and Munger’s lack of leverage caused them to underperform Guerin when things were good, in most scenarios, a retiree’s emergency reserves will cause his total portfolio to have lower returns. But the goal in retirement is not to outperform a benchmark.  The goal is to not run out of money and in a world where extreme events happen all the time, investors need to plan accordingly.