How Does The Sequence of Portfolio Returns Impact Your Financial Journey?

A portfolio's sequence of returns refers to the order in which investment returns occur over time. Although often overlooked, understanding this phenomenon is crucial for those with long-term savings goals, such as retirement. The sequence in which gains and losses occur can significantly influence the sustainability and overall performance of an investment portfolio, particularly when distributions are involved.

Understanding the Impact of Return Sequences:
If the sequence of returns is favorable—meaning the market performs well in the consecutive early years of an investor's retirement—the portfolio is likely to experience growth and positive compounding. This growth provides a cushion for future withdrawals, enhancing financial security. Conversely, if the sequence is unfavorable with early losses, the portfolio may deplete more quickly, which is especially problematic during market downturns as it locks in losses and erodes the portfolio’s value.

Examples of Sequence of Returns:
Consider two hypothetical scenarios, A and B, illustrating this concept with the same annual returns but in reverse order. Both scenarios start with a portfolio of $100,000 and achieve a compounded annual growth rate (CAGR) of 2.03% over five years, resulting in an ending value of $110,565. While both scenarios achieve the same compounded annual growth rate (CAGR) of 2.03%, the sequence of returns affects short-term portfolio health, demonstrating that consistent returns over time can still lead to drastically different outcomes based on the timing of gains and losses.

However, the outcomes differ significantly when capital transactions are involved:

• Adding $10,000 Annually: In Scenario A, adding $10,000 at the end of each year boosts the final value to $150,408. In contrast, Scenario B benefits from early dollar-cost averaging during market downturns, growing to $180,287.

• Removing $10,000 Annually: Withdrawals have a pronounced impact. Scenario A ends with $70,723, while Scenario B, suffering from early losses, drops to $40,843.

  
  

Understanding Dollar-Cost Averaging (DCA) and Its Role in Mitigating Volatility:

Dollar-Cost Averaging Explained:
Dollar-cost averaging involves systematically investing a fixed amount of money regularly, regardless of market conditions. This strategy helps reduce the impact of volatility by purchasing more shares when prices are lower and fewer shares when they are higher. In Scenario B, where early losses coincide with regular contributions, DCA effectively lowers the average cost per share, enhancing portfolio growth when the market recovers. Although dollar-cost averaging helps mitigate volatility by reducing the average cost of investments during downturns, it doesn't guarantee higher returns, making it more of a strategy for managing risk rather than maximizing gains.

The Risks of Withdrawals During Market Declines:
Withdrawing funds during a downturn can severely hinder a portfolio’s recovery. For example, a portfolio that shrinks by 20% needs a 25% gain to return to its pre-loss value. Scenario B demonstrates how early withdrawals exacerbate losses, requiring even higher returns for recovery.

Mitigating Sequence of Returns Risk:
To manage the risk of an unfavorable sequence of returns, investors should aim to reduce portfolio volatility. This involves diversifying investments across various asset classes such as bonds, stocks, currencies, and commodities. A well-diversified portfolio can smooth out market swings, better sustaining withdrawals and reducing the likelihood of running out of funds.