I like math. That may be at least part of the reason I have worked in this business for the past 30 or so years.
However, when I explain concepts such as mean, average, median, standard deviation, alpha, beta, most times I can see folk’s eyes begin to roll to the back of their heads.
For those of you who do not like math, I get it. But everyone has a responsibility to fund his or her retirement, right? Well, this is where math can be your friend or an unseen enemy.
The mathematical definition of “average” is not difficult to understand. The challenge is that many, including the so-called “experts,” place importance to these numbers without accounting for Sequence Risk. Sequence Risk is the risk of receiving lower or negative returns early in a period, when withdrawals are made from the underlying investments. What you need to understand, which is not often explained, is the difference between average rates of return and sequence rates of return.
I recently met a very nice couple who were planning to retire. They had done a fair amount of research, and met with other advisors. The other advisors had recommended they invest in mutual funds and use the common buy and hold, asset allocation, investment strategy. They had been told that over the “long haul” their investments should average about 8% per year.
So we talked about the concept of “averages” since that seemed to be the focus of what they recalled from their previous meetings. I explained that generally, when you calculate an average, you add up all the data points and then divide by the number of data points. So, if Champaign County receives 40 inches of rain in a year, the average rainfall is .11 inches (40/365=.11) I would bet even the non-math majors understand that this does not mean that every day the people of Champaign County will get .11 inches of rain. We may get 40 inches of rain in a year, but many of the rainy days are clustered in the spring.
This is when the concept of Sequential Risk starts to become very interesting.
If we were to expect .11 inches of rain every day, then golf courses would not even turn on their sprinklers. That would be a bad decision if they wanted lush fairways and greens during June, July and August when we do not get a lot of rain. Not a good decision for healthy green grass and not a good decision for a nice healthy portfolio.
I agree that the long-term average annual return of the equity markets is about 8%. But that does not mean that an investor will earn 8 % every year. Is it possible that an investor can experience while they are accumulating wealth, and then just before retirement or early in their retirement years, low or even negative returns? You bet it can.
The problem begins when an investor starts drawing income during those years with lower returns. If a high proportion of the negative returns occur in the beginning years of retirement, there is a lasting negative effect that can reduce the amount of income that can be withdrawn throughout the retirement years. This can be true, even if the investment itself “averages” 8% annually throughout the years.
Think of years such as 2000 or 2008. What happened to the person who was entering retirement during those years?
The timing of returns can be everything. And managing downside risk is crucial.
If you get high returns early in your working years, when you are not drawing on your investments, you begin to feel financially secure, confident that you are going to be okay in retirement. But what if you were unfortunate enough to plan to retire in 2000, or 2008? Many folks saw their wealth evaporate with each breath they took. For those drawing on their retirement accounts, well, many of them just could not recover. They may have expected their investments to average 8 % annually, but the sequence of those returns led them to massive losses just when they could not afford it.
So, the lesson here is that while it is important to understand “average” rates of return, it is the sequence, or the order in which returns are earned, that is crucial to a sound retirement.
Math and non-math investors alike must understand that sequence of returns can trump average returns. You must examine how much risk you are taking and what potentially lies ahead. With both the geo-political unrest and the weakness in the economy, now is not the time to be blindly taking on large amounts of risk, especially if you cannot afford sequential years of low or negative returns.
The markets are cyclical and history seems to repeat itself. The truth about risk is that no one can predict the future, but you can certainly prepare for it. With the markets being close to the highest they’ve ever been, it’s important to protect your money.
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