Why Sequence Of Return Matters So Much

Let’s pretend we have two retirees, Jim and Marty McFly. They both look the same financially. They are retiring in the year 2000 with $1,000,000, all invested in the S&P 500 and plan to begin withdrawing $40,000/year (increased 3% for inflation each year). The only difference is that Marty McFly has the ability to travel to 2020 and do retirement in reverse. So, Jim’s first 20 years of retirement will be 2000, 2001, etc… and Marty’s will be 2020, 2019, etc…

Over the next 20 years, the annual returns of each of their investments are the following:

They each got the same returns, just at opposite points in their retirement. The end result?

 Jim has $169,000 left.

Marty has $2,249,000 left.

Simply put, the bad returns early on ate into Jim’s nest egg so that when the good returns finally came, there wasn’t much left to earn on.

The problem that many retirees have is they never know what hand they’ll be dealt. So, what do you do about it?

(1)   Have a plan B – For example, if we get below average returns over the next 10 years, what will we do to keep our plan on track? Get a part-time job? Cut expenses?

If Jim had decided to get a job (or cut expenses) when the bad returns came in 2000-2002, and not withdrawn $40,000 for the first 3 years, and instead started withdrawing in 2003, he would have $966,000 instead of only $169,000 after 20 years!

(2)   Don’t put all your eggs in one basket – This is an extreme example since very few retirees would put all their retirement savings in stocks. If for example, Jim had a portion in bonds, he would have been able to weather the storm much better.

(3)   Have an investment plan – If Jim had diversified into bonds and then systematically rebalanced, selling bonds and buying stocks when stocks were down during 2000-2002, he would have been much better off.

Thank you for reading,

Alex

This blog post is not advice. Please read disclaimers.