Sequence of Return Risk


The word risk gets thrown around quite a bit by the financial planning industry. Usually they like to talk about risk in terms of diversifying your ownership of assets [in practical terms they are really encouraging you to buy mutual funds]. They like to mention those companies that imploded, like Enron or Global Crossing or AIG to scare folks into buying what they want them to [ironically mutual funds that probably owned all three of those companies].
But there are more critical risks to your retirement goals than some outlying companies that acted fraudulently or at least recklessly. How many of those financial planner types have talked to you specifically about sequence of return risk? Do you even know what that is?

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Sequence of Return Risk

The order in which your investment returns occur.

I hesitate to even call it a risk, because I think of a risk as something that might occur, but probably won’t. To further define SOR, I think it is the risk that a large loss of value will occur within 5 years before or after a planned retirement. If you are investing in an equity or a mixed mutual fund that risk is greater than 90%, or you have a greater than 90% chance of a large loss [greater than 25%]of value during that 10 year time period.

Related: Football, Fear, and the Investor’s Mindset: Musings on Risk

If you are an institution, that risk doesn’t matter as your plan as an institution is to never need to use the institutions endowment. Same with pension funds, which are able to predict payouts using actuarial tables. However, the individual is a different story. Most individuals plan on using those investments to produce retirement income. They don’t have decades to make up for bad market years. Once they start taking income, then they will never have a chance to make up for bad market years with the money they used. So for the individual, bad market years as they approach retirement or in early retirement are a double whammy, which can and will devastate even the most successful saver’s retirement. So I repeat, historic evidence points out to a 90% chance of this occurring.

Financial planners came up with a fix, that they call asset allocation. Really, all they suggest is that you move money from equities and the large variation of return you get from them to other assets like bonds which have lower increases and decreases as you age. The so-called 100 rule where you subtract your age from 100 and invest that percentage in equities. But, what they don’t tell you is that decreases your expected returns significantly. So the equities market might return 10% over a lifetime, but the bond market doesn’t resulting in lower overall returns. And even this idea doesn’t fix sequence of return risk, only dampens the effect.

So, perhaps the majority of folks saving for retirement in the US, are heading straight for that brick wall at 100MPH.

Related: The Truth about RISK

How to AVOID Sequence of Return Risk

Let me tell you a little secret I discovered that led me to sell all my mutual funds. It’s not the total value of your assets that is important, it is how much annual income you can generate that is critical in retirement.

You need to invest in ways that secure the income and forget about what the assets are worth on a year to year basis. For those of you on here who invest in real estate, you are on the bus to a fruitful retirement. Growth of your real estate value is inconsequential to the real metric which is how much cash flow your real estate is throwing off. [Flipping houses is an entirely different model and does not eliminate sequence of return risk]

There are two other ways that complement your real estate investing:

1. Study and become an expert in equities that pay dividends. There are some companies that have paid dividends at an increasing rate for decades. Investing in these large companies can give you an income stream that grows every year. I have an opportunity to meet someone who was a Coca-Cola millionaire when I was 19 years old. His father had bought stock in Coke back in the 1930s. He was raking in several hundred thousand dollars a year [as was his siblings]in dividends in the 1980s all from an investment of less than $4,000. There were folks just like him all over south Georgia. The point is you don’t sell the companies, just spend the dividends which means the change of value in the short term [10 years or less] wouldn’t effect your retirement income.

2. EIUL: By eliminating losses in your cash account you minimize sequence of return risk and can take out as income a higher percentage of your account value. You also realize higher average returns because you eliminate those negative years.

Proper financial planning must include dealing with sequence of return risk. Eliminate as much of that risk as you can as it will destroy your bountiful retirement.

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    • Kevin, I am totally perplexed on your question. Warren Buffett runs a firm that uses insurance float to buy assets [equities, whole companies, bonds, etc.] Although he has stated his preferred holding period is “forever” not every stock he buys is kept forever. He is a value investor that purchases assets when they are on sale. Perhaps his most successful stock purchase is Coca-Cola. In one of his most recent letters he brags about the “dividends” he receives from coke. Dividends he receives are part of the ability of Berkshire to have such strong cash flow in good and bad markets. He is an atypical dividend investor. Since 1990 he has been more interested in purchasing whole companies so he can capture all the cash flow for Berkshire, instead of relying on the dividends. He doesn’t have sequence of return risk because Berkshire doesn’t rely upon stock sales to create income. It is a never-ending institution [in theory] so it never cannibalizes its assets for current income.

      • David, you are discussing “sequence of return risk” and state that it is the risk of substantial loss withing 5 years (or 10 years?). If that is the case, Warren Buffet should have gone bankrupt. In interviews when asked “when is the best time to sell a stock?” Warren has consistently answered “never!” Although I also understand that he regrets holding some of his positions (Gannett, Washington Post) for so long.

        I understand that their is a major difference in the goals and strategies for investing between Berkshire Hathaway, a holding company and an individual who invests for retirement.

        But please tell us, which company is the next Coca-Cola which will be fruitful and increase in value and start kicking off dividends that increase over the next 50 years.

        • Kevin, you left out the important part. SOR risk is risk of substantial loss of value within 5 years before or after RETIREMENT. That one word makes all the difference. Berkshire Hathaway isn’t going to retire and live off of selling its stock holdings. In fact, Warren does exactly what I suggest in owning high quality companies that pay increasing dividends over long periods of time.

          I suggest those interested in this strategy start by researching “dividend aristocrats.”
          You might want to start there yourself. There are several really good websites that outline the strategy and list stocks that fall into the category you are asking me about.

          As to my personal investing, I have been blogging about it since 2007 and document what I bought and when since then along with my current yield to cost for the part of my portfolio that is dividend producing. And by the way, I have been accumulating Berkshire Hathaway since around 1998. So I know a little about what Buffett invests in. 🙂

    • Kevin,

      Would you settle for a stock that has paid increasing dividends for the past 57 years?

      They exist. They just aren’t talked about as commonly as many other trading practices. Most financial news seems focused on short term trading. You need to tune that stuff out and focus on the long term. I don’t own PG, but have invested in a handful of other stocks, as is mentioned on my blog.

      Stocks are not the primary component of my wealth building strategy. I primarily invest in real estate, but I also buy stocks that have a strong history of growth and dividend payments as well as storing money in a tax advantaged EIUL. When combined together, they beat the performance of mutual funds inside 401K wrappers. It also gets me away from mutual funds in general and the impacts that occur when people cash out in a down market.

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