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    August 2013
    M T W T F S S
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    When is Market Volatility Most Dangerous?

    Guy Conger

    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.

    The MONEY® Network