Understanding sequence of returns risk
A little math for a volatile market
The U.S. stock market has been super volatile, hasn’t it? And who knows when it will let up. You may hear about sequence of returns risk. What is it?
Over time, returns average out. If the market is up 5% one year, up 20% the next year, and down 10% the third year, the investor’s return will be 13.4% over the three year period. And that will be the same no matter what year the 10% loss occurs.
1000 x 1.05 x 1.20 x .90 = 1134
1000 x .90 x 1.05 x 1.20 = 1134
1000 x 1.20 x .90 x 1.05 = 1134
But, if you have to take money out the year that the market loses money, then you won’t have money in the market the year that the market goes up. That’s where the risk comes in, for people who want to take money out of their stock market accounts for things like retirement or college education.
If you have to take money out when the market is down, those funds won’t benefit from a future increase. That can set you back the entire rest of the time that you need the money.
There are two ways to deal with it. The first is to save more money than you need. That gives you protection, but the cost is that you’ll have less money to spend and maybe have to wait longer to do whatever it is that you’re saving up for.
The second is to diversify away from stocks the closer you get to needing the money. That way, you can pull money from your cash or bond account and let the money in the stock market ride for a while.
A down market sucks, no doubt about it, but your best bet is to keep your money in as long as you can.
Here’s a snazzy chart I found on the Northwestern Mutual website:
It’s what’s known as a quilt chart, and it ranks different investment categories by their return each year from 2010 to 2024. Each square is a different asset, with its own color. If you follow any particular asset, you’ll see that its performance goes up and down a lot. Over this time period, US large cap stocks (the standard index fund holding) performed the best, but it wasn’t the best every year. Most of the time, one bad year was rewarded by one good year.
You can also see that low risk assets, like cash and bonds, didn’t offer great long-run returns, but they did help cushion returns (see the performance of the diversified portfolio).
All of this is a reminder not to panic about the stock market, but also not to take withdrawals from your market account right now if you can help it.
Does that make sense? If not, let me know.