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Decoding the Impact of Return Sequences

June 22, 2023

Decoding the Impact of Return Sequences: A Deep Dive

When it comes to assessing an investment portfolio's final value, one crucial factor to consider is the sequence of returns. This term refers to the annual fluctuations in the rate of return that a portfolio experiences. But what exactly is the impact of these deviations from the average return? In this article, we'll delve into different investment scenarios and explore how they shape the sequence of returns.

A comprehensive study conducted by BlackRock shed light on the manageability of return sequences during the asset accumulation phase. The analysis compared three hypothetical investment scenarios, each involving investors who initiated their portfolios with lump sums of $1 million. All three portfolios maintained an average annual return of 7% over a span of 25 years. However, the annual returns in two scenarios fluctuated between a hypothetical range of -7% to +22%. In the third scenario, the return remained a consistent 7% every year. Surprisingly, all three investors accumulated the exact same total amount of $5,434,372 after 25 years. This equality in outcomes can be attributed to the fact that the average annual return remained constant at 7% across all three portfolios.

It's crucial to bear in mind that investing inherently carries risks, and your investment decisions should be driven by your personal goals, time horizon, and risk tolerance. The value of investments and their returns will fluctuate as market conditions evolve. Upon selling investments, they may be worth more or less than their initial cost. In the BlackRock study, it was assumed that the hypothetical investors assessed their financial capacity to sustain purchases during periods of both declining and rising prices.

However, as you transition from asset accumulation to asset distribution, the narrative can take a different turn. There is an inherent risk that your distribution strategy might align with a period of declining prices, which can pose significant challenges. To illustrate this point, let's consider the bear market experienced during 2007-2009. In this hypothetical scenario, an investor entered 2008 with a $1 million portfolio, with 60% allocated to equities and 40% to fixed-income investments. The investor was set to retire in just 12 months, precisely on December 31, 2008. During that year, the bond market, as represented by the S&P U.S. Aggregate Bond Index, saw a rise of 5.7%. In stark contrast, the stock market, represented by the S&P 500 Index, suffered a substantial loss of 37.0%. Consequently, the $1 million portfolio dwindled to a year-end balance of $800,800.2,3

If the hypothetical investor had commenced taking distributions in January 2009, they would have done so with a smaller portfolio balance, making it challenging to regain the principal lost during the preceding 12 months. For individuals approaching retirement, understanding the sequence of returns becomes paramount, as it prompts essential inquiries regarding their overall investment strategy.

In conclusion, comprehending the impact of return sequences is fundamental to sound investment decision-making. By unraveling the intricacies of this phenomenon, investors can navigate the complex terrain of asset accumulation and distribution more effectively. Remember, consulting with a financial advisor who understands your unique circumstances can provide valuable guidance throughout your investment journey.