“I been in the right place, but it must have been the wrong time.” – lyrics from the song “Right Place Wrong Time” by Dr. John
Last month I read a research article that was published by the CFA Institute with the simply tantalizing title Reducing Sequence Risk Using Trend Following and the CAPE Ratio. I know…I know…it is taking every ounce of self-discipline in your body for you not to click on that link and read the article for yourself! As is the case with pretty much every article that is published by the CFA Institute in the Financial Analysts Journal (FAJ), the article is chalked full of mathematical equations and industry lingo. That being said, the point the author is making is one of extreme importance, which is why this week’s Insight will attempt to explain the same concept using plain English and examples instead of industry lingo and equations.
There are many different ways to define risk when it comes to investing. Some define risk as the volatility of an investment’s returns (e.g. how much does it rise and fall over time) while others may argue that volatility is simply noise and that a better measure of risk might be the maximum peak to trough drawdown for an investment, which if significant enough can cause people to make very poor long-term investment decisions due to the cost of being human. But one risk that is often overlooked and rarely ever talked about is sequence risk. What is sequence risk you might ask? Well, quoting the aforementioned FAJ article it is, “The risk of experiencing bad investment outcomes at the wrong time.”
To unpack this concept, let’s work through an example. In our example we are going to use three different investors A, B, and C. All of our investors just retired with a nest egg of $2M and will require distributions of $100k/year (5% of their starting portfolio value) to cover living expenses. For purposes of our example, each investor is going to realize the same returns over a 10 year period with the only difference being the order in which those returns occur as shown in Table 1.
All three investors experienced the same average annual return, compounded annual return, volatility, and maximum drawdown over the 10 year hold period. (As a side note, you can learn more about why average returns don’t match compounded returns in our Economics of Loss video.) The only difference is that the negative returns were in the last three years for Investor A, in the first three years for Investor B, and in the middle years for Investor C.
Now one might think that since all three investors compounded the same annual rate of return and took the same amount of risk as defined by volatility and maximum drawdown, the ending portfolio value for each investor should be fairly close if not exactly the same, but that is far from the truth as Table 2 clearly illustrates. The reason it isn’t true is because of sequence risk.
Investor A had the luxury of experiencing strong gains every year for the first seven years which was followed by three negative years. During the first seven years, the portfolio grew from $2M to $5M even after accounting for the $100k of annual withdrawals and had a portfolio value of just over $2.3M after 10 years. Investor B on the other hand was not so lucky. He/She got hit with three negative return years right off the bat and his/her portfolio dropped from $2M down to $825k in three years as the $100k withdrawals were only further compounding the pain of the negative performance. Even though Investor B was able to “right the ship” and post 7 consecutive years of positive performance thereafter, the portfolio value at the end of 10 years was still down to $1.2M. Investor C ended up somewhere in the middle of Investor A and Investor B finishing with a portfolio value fairly close to where they started at $2M.
To put this in perspective, Investor B ended with a portfolio value roughly half the size of Investor A and two-thirds the size of Investor C simply because he/she realized the three negative return years at the beginning rather than at the end or in the middle of the return stream. After 10 years, a $100k annual distribution would account for 4.3% of Investor A’s, 8.1% of Investor B’s, and 5.0% of Investor C’s portfolio. Investors A and C will most likely be fine through the remainder of their retirement but Investor B is now in serious risk of outliving his/her portfolio.
This is why every investor who is taking distributions out of their portfolio needs to understand the importance of sequence risk. It isn’t good enough to simply be in “the right place” (e.g. stocks for the long run) because it might end up being “the wrong time” (e.g. a recessionary cycle) when you start pulling money out of the portfolio.
At Season Investments, our answer to this problem is to build robust portfolios which spread risk across a wide variety of asset classes while proactively managing the downside using mathematical trend following disciplines. In order to manage risk in this fashion, we have to be willing to lag individual asset classes like the stock market during raging bull markets, for the benefit of reducing volatility drag, sequence risk, and the cost of being human. By managing these three things we increase the likelihood that our clients will actually stick to an investment plan through all market environments and not outlive their money. That is, after all, the main value-add of an investment advisor and something we strive to achieve for our clients every day we come into work.
P.S. For those that are anything like me, you’ve been hearing Dr. John’s song in the back of your head ever since you read the title or the opening quote of this post. For all of you, I give you this.
Author Elliott Orsillo, CFA is a founding member of Season Investments and serves on the investment committee overseeing the management of client assets. He spent nearly ten years as a financial analyst and portfolio manager working primarily with institutional clients prior to co-founding Season Investments. Elliott earned a bachelor's degree in Engineering from Oral Roberts University and a master's degree from Stanford University in Management Science & Engineering with an emphasis in Finance. Elliott and his wife Gigi have three children and like to spend their time outdoors enjoying everything the great state of Colorado has to offer.
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