From the Archives of TGIF 2 Minutes….
There is an element of luck involved in investing. A specific term for this luck is, “Sequence of Returns.” What on earth is that? Answer: it is a risk. And it may just be the most important concept in the world if you ever wish to spend your savings – and have them last as long as you need.
Obviously, there are numerous risks and concerns with any portfolio or plan. One of these risks is “sequence of returns.” The term is not as complicated as it may sound. Sequence is a fancy word for timing. Returns means what the portfolio earns, whether negative or positive. So, the timing of negative or positive returns becomes a significant risk when you begin to spend your portfolio rather than continue to plow money into it.
Yes, at some point, most of us will actually spend the money we worked our butts off to save. You may already be in that stage. The optimal timing for spending from a portfolio is when the portfolio can afford to be spent. Have you ever heard of the “4% Rule”? The concept of being able to – someday – comfortably spend 4% of a portfolio year in and year out while still being able to preserve that “nest egg” portfolio?
- For example, if you accumulate $1 million someday, then move into “spend” mode, this equates to being able to spend $40,000 per year from the portfolio and preserve the $1 million nest egg. Accumulations of $5 million and more mean similar math and it is tempting to spend more than the 4%, or $200,000 per year in the $5 million example.
BUT (there is always a “but”) – what if, at the time you decide to retire or spend a chunk of the money, the market return is suddenly negative? And not just negative but similar to the negative returns we have received recently? That timing – or “sequence of [negative] returns” – could be poor for the start of retirement. One of the keys is to be flexible. Flexible in terms of timing of retirement and flexible, most important, in terms of how much you spend.
Here is where luck comes in. We all know that luck is mostly unpredictable and comes in good varieties and bad. A person could have been “good lucky” and stopped working in 2016 – with two amazing years of stock returns to boost the nest egg right from the start. OR, a person could have been newly retired in 2007 and 2008 (bad luck) and have had to hunker down not able to buy new things, not buy a bigger house… and put off major purchases for several years.
Do not become discouraged; there are ways around planning for both good and bad luck.
- The simplest of things is having an emergency fund or “buffer” of cash available,
- the more complicated solutions involve types of income guaranteed by insurance or annuity contracts,
- and there are all sorts of solutions in between.
Understand “sequence of returns” and please let me know if I can break it down for you. Planning is one of the best defenses against bad luck. And flexibility is key as well.