Sequence of Return Risk and Standard Deviation
Joshua Overbeek, AWMA?
Financial Advisor at Provisio Retirement Partners | Building a business of young professionals and small business owners looking to gain confidence in their financial future.
I hope you are all having a great start to the week whether you be here in cold and rainy Michigan or if you found your way down south for some warmer weather. As the calendar has now flipped to April, I think we are all hoping for consistently warmer temperatures moving forward. I can’t complain as we have had some spurts of abnormally warm temperatures this Spring, but all I’m looking for is a little consistency. That is probably too much to ask for in Michigan, though. Today’s blog doesn’t have anything to do with Spring flowers or arch Madness. Instead, we are going to talk about Sequence of Return risk and how differences in the standard deviation of portfolios can cause wildly different results in retirement. It may not sound like the most fun topic, but stay with me, it’s actually quote interesting.
When investing for retirement you have choices to make regarding the investments that you want to put your hard-earned money into. Often times when reviewing an investment or a portfolio of investments you may have a variety of questions concerning those investments, but those questions usually boil down to two questions: What is the historical annual percentage return for the funds that make up my portfolio and what kind of risk am I taking to reach that number? It is easy to look at two portfolios that average the same annual return and believe that they will result in the same nest egg for retirement and throughout retirement. There are other factors that come into play.
Let’s start with differences in standard deviation before discussing how those differences result in sequence of return risk in retirement. Two identical portfolios that have the same annual percentage return and have the same total amount invested will have different results if they have different standard deviations. As a refresher, standard deviation is simply the amount that your variable will deviate from the average or mean. If you have a portfolio that average 5% but has a high standard deviation, on a year-to-year basis you can have large deviations from that 5% return that all average out to 5%. Consider the example I have below.
Fund A and Fund B both average 5.2% annually over the five years recorded, but because Fund A deviates less from that mean of 5%, Fund A has a higher balance after 5 years. Over the life of someone’s accumulation phase for retirement this difference can be the reason they have tens of thousands of less dollars to retire on. It is important when monitoring your investments to make sure that your aggressive choices are providing proper returns for the risk they are taking on and your conservative investments are not leaving you exposed to unnecessary risk. Make sure your risk matches the return.
While standard deviation matters in the accumulation phase, that sequence of your returns can matter even more in your retirement. Having a bad investment year at the start of your retirement can spell trouble whereas having a great year one can propel your retirement savings to greater longevity. Consider the example from JPMorgan below. Each of the three retirees have a nest egg of $1 million dollars when they retire and their individual portfolios average 5% annually. They are invested differently but have the same average annual return. The three retirees also each withdraw 4% of their funds each year and that number is adjusted annually for inflation. Retiree #1 earns a steady average of 5% a year. Retiree #2 begins retirement with great returns to start but finishes with some bad years at the end. Retiree #3 has a bad start to retirement, but the returns pick up near the end.
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All three of these examples average 5% returns on there portfolios but have vastly different retirements! Retiree #1 gets 5% return each year which is enough to outpace his starting withdraw rate of 4% for long enough to leave them with $585,000 at the end of their retirement. Retiree #2 must be invested more aggressively and has some great return years to start retirement which are good enough to outpace their withdrawal rate and bad return years leaving them with $1,592,000. On the flip side, Retiree #3 is also invested more aggressively, but their investments see a bad start at the same time they start withdrawing money. This is too much to overcome and they run out of money with 8 years left in their retirement.
Why do I show this? It is important to realize that you need to balance risk when you retire. You can choose to be invested in a portfolio that has a higher standard deviation and is riskier and you may have some great market years that launch your retirement savings further. Or, you end up not only taking money from your account, but your investments have a few bad years as well and you are left with less money than you had planned for. It can be helpful at retirement to balance risk and diversification while also looking into investment options that will offer guaranteed income similar to that of Retiree #2. Often times when we are working with clients it is a combination of invested assets and annuities that offer income options that we use to plan for their retirements. It’s no “one size fits all”, but that is part of the fun of helping clients navigate what life looks like when they are done working.
Thanks for reading this week’s blog! We will see you again next week.
Securities and advisory services offered through LPL Financial, a Registered Investment Advisor, Member FINRA/SIPC. The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All investing involves risk including loss of principal. No strategy assures success or protects against loss.