What is sequence of returns, and why does it matter?

Sequence of returns may not be a phrase you hear too often, but it’s something that can have a profound impact on your ability as an investor to successfully meet your financial goals over time. So what is sequence of returns, and why does it matter so much? In this article we’ll explain the basics and show you what it can mean for your investment planning—and how you can navigate it.

Why not just rely on the historical average of returns?

All too often investors build their savings and wealth management strategies on historical average returns. This is an overly simplistic picture of market performance, because a historical average assumes a constant rate of return through all time periods. Actual experience, however, does not produce a constant return—that average can be made up of highs and lows that may vary quite dramatically from year to year.

Take the last 30 years as an example. Looking exclusively at the historical average, the S&P 500 returned just under 10% per year. Going only on this number, a person who invested $10,000 about 30 years ago should have approximately $273,000 in savings right now. Sounds simple, right?

It is, and that’s the problem. Historical averages are simple, and actual experience is not. For one, they don’t account for varying cash flows, such as deposits and withdrawals that is unique to each investor.  In addition, over those 30 years, there were years where the return was higher than 10%, and years where it was lower than 10%. While 10% was the overall average over that period of time, any given year could have had returns in the negative or in the double digits. And that’s where sequence of returns comes in.

What is sequence of returns?

Sequence of returns refers to the order, or sequence, that varying rates of returns come in over your investment lifecycle. For example, if there were lower rates of return when you were a new investor with only a small amount of savings, and higher returns later when you had had a chance to accumulate some wealth, that sequence could be very advantageous to you.

On the other hand, high returns when you have next to no savings won’t benefit you very much, while low returns when you’ve had 25 or 30 years of accumulation can slow your progress. A sequence like this could create a much more difficult environment for growing and/or maintaining wealth.

How to manage sequence of returns risk

No one has control over how the sequence of returns will play out over the phases of an individual’s investment lifecycle, but there are ways to manage the risk involved. Here are a few of them:

  • Be a nimble investor. Simulators and retirement plan calculators factoring in historical return data aren’t realistic and don’t account for the ups and downs behind the averages. Working with a trusted financial advisor can help you be purposefully flexible with your spending and saving to better manage the impact of fluctuations in returns during the accumulation and distribution phases of your investment lifecycle.
  • Build a margin of safety. Give yourself a buffer when you set returns expectations and make projections about inflation, taxes, and other factors. Be careful about overspending when returns are good so you have a cushion for the times when they will inevitably not be as robust. Building a margin of safety can give you stability and possibly stave off the possibility of having to sell when stocks are down because you’re strapped for capital.
  • Play the long game. It’s easy to get caught up in the excitement—either enthusiasm or panic—of a market trend or newspaper headline, but long-term success is more likely with an intentional, long-range financial plan. Knowing how to manage investment decisions and emotions through the unavoidable short-term ups and downs of the market can make all the difference as you work towards your ultimate financial goals.

Contact N1 Advisors today to learn more about what sequence of returns is, why it matters, and strategies you can use to increase your likelihood of managing risk as you plan for your financial future.