Investing in alternative ventures, such as assisted living facilities, during unprecedented market weakness is not only wise, but critical. Most investors fully grasp the need for consistently positive returns. However, current market turmoil has exposed investors to another risk few knew existed; the risk of a negative sequence of returns.

Not only does your portfolio need to experience positive returns before retirement, but it must receive positive returns after retirement. You may be surprised how market volatility or the random sequence of market returns can affect the assets you’ve spent many years growing. The affluent investor approaching retirement cannot remain exclusively in a market that may infuse negative, unrecoverable returns into their portfolio. Investors must diversify in privately held assets that stabilize public holdings. Let’s research why this is so important.

Numbers Never Lie…Most of the Time

How would you explain the difference between these yields?

8%, -11%, 14% vs. -11%, 14%, 8%

What would be your response? Most would pause for fear of a looming trick. The numbers are exactly the same, just in different order. The sequence doesn’t matter, or does it? Over time, oscillating returns combined with retirement withdrawals can have an amazing effect on liquidity and its duration.

The sequence of returns refers to the chronology of when the market bestows positive and negative yields into your portfolio. All things being equal, investment returns drive a portfolio’s growth. During the accumulation phase, the order in which yields are experienced are of no effect. However, this same market ebb and flow during retirement can result in a devastating blow.

A portfolio’s fall in value during the accumulation stage has little financial impact to the lifestyle of an investor, as they would not be taking current income from the portfolio. But, if the same sequence of declining returns occurs in retirement years, the income available to be received on an ongoing basis stands to be substantially less.

Let’s say an investor takes a 5% annual distribution during retirement when the market has his portfolio down -15%. This can result in a storm of negative compounding. If in the very next year, the market is again down -10% he is now taking a 5% distribution from a smaller pool. One can see how quickly money that took 30 years to grow can evaporate in half the time.

For example, let’s further assume that investor x had a portfolio value of $1 million the year prior to retirement. She estimated her yearly income stream would be in the $50,000-$60,000 range. What if in the year of her actual retirement the market declines by 20%? There would be enormous dilution to her pool of funds. Her portfolio would decline to $800,000. The next yearly distribution may only render $40,000-45,000 from the same portfolio.

Not only would the income received be reduced, the amount remaining in the portfolio would be less, ultimately affecting the sustainability of those assets throughout retirement. The probability of the portfolio running out of funds too early would increase. This is why it is vital to diversify a portfolio with defensive, privately held positions that have very little beta, or correlation to the broader market.

Signs

There are several factors that can affect a portfolio’s performance during its accumulation stage, including:

Wllingness to Save

The percentage of an individual’s income they are willing to save on an ongoing basis will dramatically affect portfolio value at retirement. The more wealth accumulated, the less the sequence of returns will impact the portfolio’s future value and income producing activity during retirement years. The more hay in the barrel, the less you notice when a few straws are lost.

Average Annual Returns

The return that the portfolio achieves annually will drive the portfolio’s overall value, and the impact sequence of returns may have on it. One must stay invested in order to achieve decent aggregation over the years.

Asset Allocation-

The diversification and strategy that is used during portfolio accumulation can help to buffer the portfolio’s value from the sequence of returns effect. Privately held assets that do not fluctuate with the broader market can be very wise investments during good and bad market cycles.

At the End

Research magazine in June 2006 published interesting findings from York University professor of finance, Dr. Moshe Milevksy. He stated, “If there is a bear market, the sustainability of your portfolio will be a lot lower. You won’t be able to make it through retirement with the same level of spending. You’re headed for retirement ruin. The earlier you have bad returns, the worse it’s going to be for your retirement. So, for the first few years, you need to protect your portfolio.”

Developing and executing proper asset allocation strategies prior to and during retirement can work to protect your portfolio from the negative effects of this little know risk, sequence of returns.

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