When reviewing investment alternatives, average annualized returns are important, but they don’t tell the whole story. The sequence of returns matter as well. And as we’ll see, while they can have an impact when accumulating savings, their effects can be more dramatic for portfolios in distribution, such as during retirement.
Average Returns Only Tell Part of the Story
Thinking about different investments and their performance, the first thing most of us want to know is what has the average return has been. After all, it’s an easy way to compare different investments. If you put $1,000 into an investment that averages a 7% annual return over the next 10 years and I put mine in a different investment that only averaged 5% each year, you will wind up with more money than me ($1,970 vs. $1,630)
However, most of us don’t start with lump sum but rather make contributions to our investments over time. So let’s say that instead of having $1,000 up front, we started with $100 and added $100 per year to our investment for a total of $1,000 contributed. Would your 7% average return investment still have performed better than my 5% average return?
Sequence of Returns Matters
Since returns vary year to year, when investing money on a regular basis over time, the ‘sequence of returns’ can matter as much, or more than the average return.
If both the 7% & 5% investments performed close to their average each year, then yes, the higher average return will come out ahead. But, we know that when it comes to investing, most of the time we don’t get the average.
For example, from 1928 to 2016 (89 years) the U.S. stock market has averaged 9.5% per year. However, there have only been 3 years when the actual return fell between 8% and 11% (Source: Standard & Poors, Aswath Damadoran).
Let’s look at the following hypothetical charts. Both show a starting investment of $100 with an additional $100 added at the end of each year for a total of $1,000 invested over 10 years.
Chart 1, with the 5% average return over 10 years, grew to $1,590. Chart 2, with the 7% average return, only grew to $1,306. How is this possible?
Looking closer, we see that both of the investments had 2 negative years, down 17% and down 4%. The rest of the years were positive, more so in Chart 2 (7% Return). However, the negative returns in Chart 1 happened early in the 10 year period when there wasn’t much money in the account. In Chart 2, they both happened later after most of the money had been contributed. Clearly, when the negative returns happened had a substantial impact.
When saving for retirement, aka “accumulation” mode, returns in the early years don’t matter nearly as much as performance in the later years when the portfolio is larger.
Sequence of Returns Can Make or Break a Retirement Nest Egg
The opposite is true when taking money out of the account on a regular basis, which typically happens during retirement. In this case, performance in the early years can matter much more than performance in later years.
Let’s take the original 7% average return chart and instead of beginning with $100 and adding to it each year, we begin with $1,000 and take a $100 distribution from it each year.
At the end of 10 years we end up with $652 left in the account.
Now let’s reverse the sequence of annual returns and see what impact that has. The year 1 return is now exchanged with year 10. Year 2 is switched with year 9, and so on. What happens? At the end of the 10 years, only $289 is left.
Let that sink in for a moment. These 2 scenarios have the exact same average annualized 10 year return. The only difference is the sequence of returns was reversed. Because of when the returns hit, one account has over twice as much money left as the other!
When in “distribution” mode, performance in the early years can have a significant impact on the ability for a nest egg to last throughout retirement.
With a well-planned distribution strategy, strong performance in the early years can actually permit increased distributions or a larger inheritance. Conversely, negative performance early on, in combination with an overly optimistic withdrawal strategy, could put the portfolio in jeopardy of not lasting as long as needed.