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Part 2: Sequence of Returns Risk - A Crucial but Often Overlooked Factor


This is part 2 of the 4-part series on financial projections for achieving financial freedom. If you’ve not read the first part, I’ll suggest reading that post first and/or watch my YouTube video above (give some support to my first video!), which explains the overall framework for making projections that I’m using to plan my financial freedom journey.

Part 2: Sequence of Returns Risk – A Crucial but Often Overlooked Factor

The focus of this post is on one important section of the entire planning process – that the sequence of returns is a huge factor that is often overlooked when projecting your investment returns. If you’re lucky, a favourable sequence of returns may fast forward your retirement target by a few years; if you’re unlucky, it could wreck your retirement plans just as you think you’re almost there.

Try to recall the last time someone share about their targeted investment returns – your friend might say “I am targeting a 10% annual return”. Or perhaps when you spoke to an insurance agent, who told you that the “S&P500 has an average return of 10%”. But how exactly do we project this 10% into the future?

A very common way of “projecting” these future returns would be to simply extrapolate the expected annual returns and compound it over the intended time horizon.

For example, if someone intends to invest $10,000 per year, and targets a 5% annual return over 10 years, extrapolating this 5% across 10 years, compounded, will give you something like this:

At the end of year 10, this person would expect to have an ending capital of $132k, after investing $100k over 10 years at a 5% annual return.

But does this resemble real world stock market returns? Clearly not…

This “5% compounded annual return” is merely the long-term compounded annual growth rate – the “CAGR”. From year to year, returns may differ very significantly: In 2021 the S&P500 gained 27%, while in 2022 it fell by 19%.

To illustrate how the sequence of returns impact the returns of someone who is investing consistently over time, consider the following two examples:

What the above two scenarios show is that during the accumulation phase – the phase where you are earning an active income, saving up and investing for your retirement, apart from the obvious factors like increasing your income, reducing expenses and having a higher allocation to equities given your longer time horizon... The sequence of returns actually play a huge part in determining whether you can hit your retirement goals sooner or later.

From the two scenarios above, even though in both cases the CAGR over 10 years is the same 5%, and both people are investing the same $10,000 per year, simply because the “lucky” person A experiences the “bad” returns in the earlier years (when less capital is at stake), while the “unlucky” person B faces the “bad” returns in the later years (when more capital is at stake), they end with a huge difference in ending capital $194k vs $94k, a whopping $100k difference!

How do I account for sequence of returns risk?

Having said the above, how do I then account for the sequence of returns risk, when coming up with projections for accumulating my financial freedom portfolio?

I decided the best way would be to run a range of simulations, where the returns are randomised in each year – within a given long-term average and standard deviation. Stock market returns generally follow a normal distribution, although in the real world there are fat-tail risks that would not be captured here.

For my projections, I decided to use a 5% long-term average return, and a 15% standard deviation. These are in line with the long-term historical averages for the MSCI ACWI.

Let’s look at the same example above, but in this case applying the randomised returns based on a 5% average and 15% standard deviation. For simplicity, we will cap the maximum annual increase and decrease at +/- 30%, so that we don’t end up with too extreme numbers.

By running 30 iterations of the above parameters, we get this chart which shows the 30 scenarios.

I overlaid the “lucky” (person A, in green) and “unlucky” (person B, in red) scenarios on the chart, to show how these stand, relative to the other simulated returns. I also included the base case “straight-line 5% return” scenario (in orange), to illustrate how a range of 30 potential real-world returns may differ significantly from this base case.

Note that because the returns are randomised with an average of 5% and a standard deviation of 15%, the CAGR for the 30 simulations may end up greater or less than 5%.

Key takeaway when projecting Financial Freedom numbers

Now that we know the sequence of returns play a key role in determining the outcome of our capital accumulation phase, how do we use this to project when would we be able to retire early, which is what many of us are aiming for?

You need to know your required annual cash flows during retirement, based on today’s purchasing power. Then, adjust this cash flow figure over time to account for inflation.

You need to decide on your safe withdrawal rate. The number often being brought up is 4%, although you may use a lower figure if you’re more conservative. Alternatively, for dividend investors (like me), the question to ask is – what is the expected dividend yield I can get from my portfolio?

Lastly, depending on how much you expect to invest each year, you will be able to generate a probability distribution of when you will likely be able to reach these targets, which is either the point when:

  • Based on your safe withdrawal rate, your portfolio size can cover your inflation adjusted retirement expenses, or,

  • Based on your expected dividend yield, your portfolio can generate enough cash flows to sustain your inflation adjusted retirement expenses.

To conclude, I think there’s value in viewing things based on probabilities. By acknowledging the likelihood of different outcomes, we can make more informed decisions and prepare for a range of outcomes.

I tend to view things in life in terms of probabilities. When it comes to my investments, I take the same approach.

May the odds be ever in your favour.

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