When is Market Volatility Most Dangerous?

When Is Market Volatility Most Dangerous?
Though a market downturn generally isn’t fun
for most people, its timing can have a greater
impact on some investors than on others. For
example, a market downturn can have greater
significance for retirees than for those who are
still accumulating assets. And it has the most
impact if it occurs early in retirement. Why?
Because of something known as the “sequence
of returns”–basically, the order in which events
affect a portfolio.
For retirees, timing is everything
To understand the importance of the sequence
of returns, let’s look at two hypothetical retirees,
both of whom start retirement with a $200,000
portfolio. Each year on January 1, Jim
withdraws $10,000 for living expenses; so does
Pam. During the first 10 years, each earns an
average annualized 6% return (though the
actual yearly returns fluctuate), and both
experience a 3-year bear market. With the
same average annual returns, the same
withdrawals, and the same bear market, both
should end up with the same balance, right?
They don’t, and here’s why: though both
portfolios earned the same annual returns, the
order in which those returns were received was
reversed. The 3-year decline hit Jim in the first
3 years; Pam went through the bear market at
the end of her 10 years.
Jim’s Return Jim’s Balance Pam’s Return Pam’s Balance
Year 1 -5% $180,500 15% $218,500
Year 2 -2% $167,090 12% $233,520
Year 3 -1% $155,519 14% $254,813
Year 4 3% $149,885 8% $264,398
Year 5 7% $149,677 9% $277,294
Year 6 9% $152,247 7% $286,004
Year 7 8% $153,627 3% $284,284
Year 8 14% $163,735 -1% $271,541
Year 9 12% $172,183 -2% $256,311
Year 10 15% $186,511 -5% $233,995
As you can see, Pam’s account balance at the
end of 10 years is more than $47,000 higher
than Jim’s. That means that even if both
portfolios earned no return at all in the future,
Pam would be able to continue to withdraw her
$10,000 a year for almost 5 years longer than
Jim. This is a hypothetical example for
illustrative purposes only, of course, and
doesn’t represent the results of any actual
investment, but it demonstrates the timing
challenge new retirees can face.
Weighing income and longevity
If you’re in or near retirement, you have to think
both short-term and long-term. You need to
consider not only your own longevity, but also
whether your portfolio will last as long as you
do. To do that requires balancing portfolio
longevity with the need for immediate income.
The math involved in the sequence of returns
dictates that if you’re either withdrawing money
from your portfolio or about to start, you’ll want
to pay especially close attention to the level of
risk you face. After the 2008 market crash,
many individual investors fled equities and
invested instead in bonds. Along with actions
by the Federal Reserve, that demand helped
push interest rates to all-time lows.
However, when interest rates begin to rise,
investors will face falling bond prices. And yet if
you avoid both stocks and bonds entirely,
current super-low interest rates might not
provide enough income. Achieving the right
combination of safety, income, and growth is
one of the key tasks of retirement investing.
Seeking balance
You obviously can’t control the timing of a
market downturn, but you might have some
control over its long-term impact on your
portfolio. If your timing is flexible and you’re
unlucky enough to get hit with a downturn at the
wrong time, you might consider postponing
retirement until the worst has passed. Any
additional earnings obviously will help rebuild
your portfolio, while postponing withdrawals
might help soften any impact from an
unfortunate sequence of returns. And reducing
withdrawal amounts, especially in the early
retirement years, also could help your portfolio
heal more quickly.