Sequence of returns: risks and opportunities

Don’t be average…

If someone told you to cross a river because it’s 4-feet deep ‘on average’ you’d be justifiably upset if it turned out to be 8-feet deep in the middle with strong cross-currents.

It’s a bit the same when it comes to so-termed ‘average returns’ from investments.

It’s often said that you might expect 7-8% returns from markets on average, but that’s not much use to you if your parents got 16% and you get zero!

Plenty of investors fail to make any worthwhile returns at all from the markets, so we want to make sure we’re on the other side of that trade.

Sequence of returns

The sequence of returns risk is normally something of concern to retirees, and in particular as it relates to the risk of running out of money if markets run against them in the early years of retirement.

The graphic below shows two retirees with the same average returns (in fact their annual returns are identical, but in reverse order).

Surprisingly, over 25 years one retiree ends up broke, while the other generates outstanding results and is sitting on a handsome pile:

Fortunately there are a number of ways to mitigate the sequence of returns risk in retirement, but investors earlier in their journey should take note of this slide regardless.

And that’s because it illustrates how misleading the concept of average returns can be.

Average vs. geometric returns

The range of returns you get has an impact on your results.

For example, three periods of 5% returns delivers a better result than any other sequence of returns that averages 5%, and the greater the volatility the more detrimental this is to the final outcome.

More pertinently, negative returns can have a far greater impact on your end result than intuitively seems reasonable.

For example, if the market falls 20% in one year and then rises 20% the next, then you lose 4% of your capital, even though the average returns appears to be zero.

Remember, the geometric return is what you get, not the arithmetic average:

What the simple graphic above shows is that money invested when the market is too expensive can fail to deliver solid returns over a very long period…even when markets have been rising for most of the past 10 years.

Transfer of wealth to the patient

This is why Warren Buffett said that rule #1 is don’t lose money.

Because by being patient and investing for value in markets that are cheap, you can continue compounding your wealth at a considerably faster rate.

And, due to the nature of compounding, this can make a very substantial difference to your wealth over time.

The stock market is a no-called-strike-game, and you don’t have to swing at everything (or indeed, anything).

It’s also not a race to invest your money immediately in anything that moves (although investment advisors and groups will always produce evidence to ‘prove’ that you must invest everything right now…today).

Remember, the sequence of returns matters.

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Published by petewargent

CEO Next Level Wealth, & AllenWargent Property Buyers, with offices in Sydney, Brisbane, & London. Leading Australian market analyst, & 6-time published finance author. For more see: Qualifications including: B.A. (Hons.) Industrial History, Chartered Accountant (FCA), Diploma Financial Services (Financial Planning), Chartered Secretary, Advanced Diploma Applied Corporate Governance.

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