Looking Back On… The Luck Factor

Despite all of the calculations involved in investing, there is still an element of luck involved. A specific term for this luck is, “Sequence of Returns.” What on earth is that? Answer: it is a risk and may be the most important concept in the world if a saver or investor ever wishes to spend their savings – and have those savings last.

The topic became relevant recently when a client asked me for assistance in defining what their “concerns” should be for the long-term now that they had accumulated a decent amount of savings and investments. The desire was to continue to accumulate savings and, more important, have the monies last at least long enough to see their plan to fruition for themselves and their kids.

There are ways to plan around both good and bad luck! 

Obviously, there are numerous risks and concerns with any portfolio or plan, large or small. One of these concerns is “sequence of returns.” Sequence is a fancy word for timingReturns means what the portfolio earns, whether negative or positive. Therefore, the timing of negative or positive returns becomes a significant risk when beginning to spend (or withdraw) from a portfolio.

Yes, at some point, most of us will actually spend the money we worked our butts off to save. This spending will happen sooner or later, but optimally at a time when the portfolio can afford to be spent. The “4% Rule” is an example of the concept of being able to – someday – comfortably spend 4% of a portfolio year-in and year-out while still being able to preserve the “nest egg” portfolio.

  • For example, for $1,000,000 someday, moving into “spend” mode equates to being able to spend $40,000 per year from the portfolio and preserve the $1,000,000 nest egg.
  • Accumulations of $5,000,000 and more mean similar math and it is tempting to spend more than the 4%, or $200,000 per year in the $5,000,000 example.

BUT (there is always a “but”) – what if, at the time a saver decides to retire or spend a chunk of a portfolio, the market return is suddenly negative? And not just negative but like 2008-2009 negative? That timing – or “sequence of [negative] returns” – would be really poor! This is a true story I have experienced with clients. One of the keys is flexibility – in terms of timing of retirement and in terms of how much is spent at a particular time.

Here is where luck comes in. Luck is mostly unpredictable and comes in good varieties and bad. “Good lucky” may have meant retiring in 2016 – with two amazing years of stock returns that boosted the nest egg right from the start. OR “bad luck” may have meant being out of work or deciding to retire in 2007 or 2008 when postponing spending or putting off retirement for a year or two was required.

But do not become discouraged; there are ways to plan around both good and bad luck! The simplest plan 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. More on flexibility in a future edition of TGIF 2 Minutes.

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