Sequence of Return Risk

Making Smart Decisions with Josh Tirado

Josh Tirado: [00:00:20] Welcome to the making smart decisions podcast. I'm your host, Josh Tirado, and today we're going to discuss sequence risk or sequence of return risk or something that sounds really boring and dumb and not useful to you. But in reality, it is actually a major major risk to your retirement and your investments.

[00:01:26]That's what we're gonna jump into today. So let me give you the definition of what sequence risk is. According to Investopedia, sequence risk is the danger that the timing of withdrawals from your retirement account will have a negative impact on the overall rate of return available to the investor.

[00:01:40] Let me boil that down for you. Timing is everything. When you pull your money out of your retirement accounts can affect how much it is their long-term. Now that makes sense to me, but in reality, it's just math. Okay. It's math. It's boring, but it can really affect you. Obviously, the stock market and your investments, whether it's stocks, bonds, real estate, what have you? It does not go up in a straight line. It can go up and go down. It can go sideways, different things. You can have several bad years in a row followed by several good.

[00:02:11] You have several good years followed by several bad. You can have interspersed and in differing magnitudes. Whenever you hear people talk about the market, you often hear, Oh, over any 10 year period, the market has returned X or Oh. Since people start investing in the market, it has averaged this sort of return and gone up.

[00:02:28] Yeah. That's an average. That is not what you're getting every year. It can be more. It can be less. I'm amazed that people jump in, and they're like, after so many years, Hey, the market's supposed to average this. I don't have that. I have this. It could be more, it could be less, but that's based on timing. And that's based on the sequence of returns within the investment.

[00:02:47]Now that gets magnified. When you go to retire, and you're going to pull your money out. Let me take this a step further. In my world, you see many things to say, sequence risk sequence of return risk That sort of thing. When I do a financial plan for someone, and we're focused on the retirement and the withdrawal, there are two main things in this sort of realm that we stress test for one is called bad timing.

[00:03:07] And I think bad timing is the most practical implementation of sequence risk. Bad timing says, statistically, the worst time to lose money. Or have poor returns is in the first two years of retirement because it's at that point that you have simultaneously stopped, contributing, started withdrawing. Now your seed money, which needs to grow like a snowball rolling downhill, has been reduced by less than optimal returns.

[00:03:33] Okay. Maybe you were planning on 8%, you only got 4% of your planning on something positive, and you actually went down and lost money. So those first two years are imperative that you really protect them because you can't dig yourself into a hole there. After all, there's no more money coming in to fill in the hole, and that money needs to grow to protect you.

[00:03:49] Long-term. One of the main things that we stress test against is bad timing, where we take a look at what you're invested in and the likelihood that you'll lose money. And, those first two years of retirement, when I say lose money, It's not guaranteed. Still, historically we can look at how the investments you're holding have fared in different years and how much on average they'll go down, and we can look at, okay, here's the likelihood that they will go down in this first two years.

[00:04:11] And here's the percentage they could go down. One way you get rid of sequence risk or the bad timing risk is to diversify properly. Because rarely does everything go down or go up at the same time. So we start to reduce the overall amount of risk, and we properly diversify. And by doing that, we can dramatically reduce the chances that you will lose money in those first two years of retirement, which is the most important, but secondarily and almost as important is we run a Monte Carlo simulation.

[00:04:40]When I say the chance of you making a certain amount of money for a certain number of years, you're not living your money, is based on this Monte Carlo simulation. What do you mean? The money? Carlos simulation in my world with planning takes a look at.

[00:04:51]Not just your overall portfolio, not just the average you're holding, but it takes a look at the different types of stocks, the different types of bonds, the different types of real estate, whether it's large-cap, small company, international, whatever it is, it looks at all. And then it takes a look at historical what they've done as far as when they've gone up when they've gone down.

[00:05:09]And what is the likelihood of that happening? And the Monte Carlo simulation runs a thousand plus sometimes depending on what you're running a couple of thousand different scenarios with different sequences of returns. So a lot of good returns in the beginning followed by bad, a lot of bad followed by good, and vice versa.

[00:05:24] And it does it for every asset category that you're currently invested in. And then, we'll run a scenario showing that for all the asset categories that we plan on you being invested in. At the time of retirement, you will give you your probability of your money lasting and how much is in there. A lot of the free planning software that's out there takes a look at what average returns are and says to you, here's the number you need to have when you go to retire.

[00:05:46]But that number is really a moving target because that number might be there on the day. You retire. But your life expectancy after you retire may be 30 years. So that number is one snapshot. One day, we need to take a look at what you are invested in overall, how much you need to pull out of there, what sources you're pulling it from.

[00:06:02]And this sequence of return risk over five, 10, 20, 30 years. In fact, we look at the sequence of return risk. As to your proper asset allocation while you're still accumulating money leading up to retirement because in what order you get, your returns or losses in the market affect you even leading up to retirement.

[00:06:19]It's amplified in retirement. But it's all-important. So when you deal with the professional, we'll stress test for bad timing at the beginning of retirement. We will run a Monte Carlo simulation to stress, test you for the sequence of return risk during your accumulation phase. And we'll rerun it for the projection when you retire in your withdrawal phase to make sure that money will last.

[00:06:40] And then, on top of that, we still make sure that at the proposed end of your plan, there is still extra money there. There is still a buffer because you need more money. It would be best if you had that safety net when you're just trying to figure out a number or look at some free software to give you a number of some projections.

[00:06:56]I have never seen it where it considers all of these different variables and stress tests it for you. And that's really what you get with the professional. And that's really important. So sequence risk sequence of return risk may sound really boring. But if you don't address it, it could be one of the number one detriments to you having a successful retirement.

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