Broker Check

The Sequence of Returns

June 08, 2023

The phrase "sequence of returns" encapsulates the annual fluctuations in the rate of return within an investment portfolio. But how exactly do these variations from the average return influence the final value of the portfolio? Let's delve deeper into different investment scenarios to understand how they shape the sequence of returns.

A comprehensive study conducted by BlackRock sheds light on the manageability of sequence of returns during asset accumulation. The analysis compared three model investing scenarios, wherein three investors commenced their portfolios with lump sums of $1 million. Each portfolio maintained an average annual return of 7% over a span of 25 years. While two scenarios exhibited annual returns ranging from a hypothetical -7% to +22%, the third scenario sustained a steady 7% return every year. Interestingly, all three investors accumulated the same total amount of $5,434,372 after 25 years. This parity is attributed to the fact that the average annual return remained a hypothetical 7% across all portfolios.

However, it is crucial to bear in mind that investing involves inherent risks, and investment decisions should be grounded in individual goals, time horizons, and risk tolerance. The return and principal value of investments are subject to fluctuation with changing market conditions. Consequently, the value of investments may rise or fall, surpassing or falling short of their original cost. The BlackRock study assumes that the three hypothetical investors assessed their financial capacity to continue making purchases during periods of both declining and rising prices.

While asset accumulation may appear relatively stable, the story takes a different turn when transitioning to asset distribution. There exists a risk that your distribution strategy could coincide with a phase of declining prices, posing a potential challenge. To illustrate this, let's consider the bear market experienced from 2007 to 2009. In this example, an investor entered 2008 with a $1 million portfolio, comprising 60% equities and 40% fixed-income investments, and was planning to retire in 12 months, on December 31, 2008. During 2008, the bond market, represented by the S&P U.S. Aggregate Bond Index, saw a 5.7% rise, while the stock market, measured by the S&P 500 Index, suffered a 37.0% loss. Consequently, the portfolio balance at the end of the year dwindled to $800,800.2,3

If the hypothetical investor had commenced taking distributions in January 2009, they would have been starting with a diminished portfolio balance, with limited opportunities to rebuild the lost principal from the preceding 12 months. For individuals nearing retirement, understanding the sequence of returns becomes crucial as it prompts pertinent questions regarding their overall investment strategy.

In conclusion, comprehending the implications of sequence of returns is vital for investors. While asset accumulation may exhibit relative stability, the dynamics change when transitioning to asset distribution. By recognizing the potential challenges associated with declining markets during distribution phases, individuals can make informed decisions to safeguard their financial well-being. It is imperative to assess one's investment strategy in light of individual goals and circumstances, ensuring a resilient and adaptable approach to navigate the intricacies of the financial landscape.