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Sequence of Returns; Redux June 2, 2010

Posted by shaferfinancial in Finance.

I posted a while back on the issue of sequence of returns here.  I think this issue is the biggest one surrounding investing, especially if you invest in mutual funds or ETFs.  I’m not going to repeat the math, but you can look at it on my earlier post.

Here is the issue.  Many investments are sold on the basis of average annual returns.  Charts are created, strategies implemented, all based on this simple statistic.  But, this statistic is very misleading because the market doesn’t work like that.  One year the market goes up a little, then maybe up a lot, then it drops a little and every once in a while it drops dramatically.  This variance is rarely talked about in practical terms.  If the market suffers a major loss close to the time you plan on using the money you have invested, it invalidates your plans.  So much in fact, that if you did retire anytime in the last DECADE, your retirement income is radically reduced.  You are using your capital instead of allowing it to grow back to that average return.  So, in fact, you never reach that “average annual return” that you were led to believe would be YOUR average return.  And here is the kicker, historically, you have a better than 80% chance to retire either right after or right before a major market downturn.  So, odds are that this will become your reality unless to lower your market presence significantly at least 5 years before you plan to retire.  And when you lower your market presence you lower your returns.

So that is what is so insidious about sequence of returns and why you need to understand it now.



1. Den's Aviva - June 2, 2010

Dr. Shafer, these types of informative articles are refreshing. Although not the same topic but similarly, many folks buy mutual funds based on ‘star ratings’ and look back periods of returns.
All mistaken assumptions as studies have shown. (this was in a recent WSJ article.)
Thanks !

2. shaferfinancial - June 3, 2010

Thanks for your kind words. In my e-book I talk about the mistake of buying mutual funds based on recent performance. But, people will be people and will always gravitate to recent relative performance indicators. Unfortunately, the entire industry has developed very effective sales strategies to mislead the consumer!

3. How to design an investment portfolio that makes sense. « Uncommon Financial Wisdom - June 3, 2010

[…] It all works together.  When you retire, you have dividends and real estate income producing income.  You can take income from your EIUL at varying levels depending upon your immediate needs.  At some point you are going to want to prepare to shed some of your real estate for various reasons, and because you have the EIUL and dividends you can do that at the most opportune time in the market.  If the stock market goes into a swoon right before your retirement or right after, no big deal because you are depending on the dividend income, not the valuation of the stock.  If you have an untimely death, your spouse and children are not financially devastated.  You, your spouse or children don’t have to dispose of real estate or stocks at bad moments in the market.   Taxes aren’t an issue as your real estate is protected with depreciation, your EIUL is tax free and dividends are currently taxed at a much lower rate.  Sequence of returns is not an issue [read my post on this here]. […]

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