When "Worst Comes First."

October 15, 2019

My son’s Little League team won their game last Sunday.  (If you do Little League, you will know about “Fall Ball”).  Despite a last-minute change of time to start the game, the team began with a few good hits and just kept building momentum.  They won by a big margin.  Two weeks prior, they showed up to the field to find they were playing a team of (seemingly) enormous boys who had a reputation for never losing.  My son’s team’s sense of inferiority hobbled them from the beginning.  They started off weak and just couldn’t get into their “zone”.  It’s similar with parkour, my son’s other sport.  I’ve noticed that the courses have easier obstacles first, with the harder ones coming later.  That’s because when a child falls off an early obstacle, s/he has trouble regaining composure.  But if the child gets a few successful clearances at first, s/he has more self-confidence and generally does better on the harder obstacles that follow.  Even as adults, when our project gets off to a strong start, we have more confidence and momentum and will probably complete it faster, more efficiently, and with better results.  Conversely, roadblocks at the beginning of an undertaking are likely to hamper both the team’s morale and the progress of the project.

 It’s a bit the same for the investment portfolio that you expect to fund a particular goal.  For example, suppose you and your spouse started saving in 2003 with the goal of having a substantial down payment for a home purchase you expected to make in the summer of 2008.  Your plan is to put $2,500/year into a Vanguard S&P 500 index fund.  You don’t want to leave the funds in a money market that is yielding only half a percent, or even in CDs where the longest you could purchase—a 5-year commitment—would still yield less than 3 %, and the short-term ones even less.  Year one, 2003, goes well. Between January 2003 and January 2004, your account is up almost 29%.  The next two years have respectable increases of around 8%.  The following year, 2006, gives you a hearty 15%; and 2007, while disappointing, still provides a modicum of positive growth.  But then—and most of you readers probably saw this coming—you reach your year of purchase, 2008.  Since no one wants to go house-hunting in the winter in the Midwest, you wait till spring to start looking.  You find an acceptable property by July, but when you look at your down payment fund, it’s DOWN by 10% from January.  That’s an “oof” as my son would say.  Well, you’re not in love with the house you found—there are probably better fits out there—and the market will surely bounce back in a few months.  Except it doesn’t.  Now, it’s late October and your account is down a full 30% since January.  You elect to wait to purchase your home until the account recovers, not anticipating that it’s going to be April of 2012 before your account returns to its January 2008 level. 

 

Intellectually, most investors in the stock market know that it will go up and down, which is known as “market risk”.  Money that is invested in bonds (particularly government bonds) or bank CDs does not carry this risk.  On the other hand, those so-called “fixed income” instruments offer lower returns, especially in today’s extremely low-interest-rate environment, so investors are often willing to accept the higher market volatility in exchange for stronger average returns.  But although the average return for the stock market will be positive and higher than fixed investments over the long term, in any one period, the market might go down sharply as in our example above.  We all know that the market DID recover from the 2008 recessional crash, but it took quite a while.  If a sharp market downturn happens in the MIDDLE of your goal horizon, then you will likely still meet your goal, because the market will have time to recover.  If the market downturn happens at the END of your goal horizon—when you are nearly there--you are almost certainly going to reach the goal because any competent financial planner will help you build in small cushion.  BUT—and this is a really big BUT—if the market tanks sharply at the BEGINNING of your goal pursuit, the early drop can significantly undermine your plan.  Because our initial example was a short-term goal, the fact that the market tanked exactly in the year that you and your spouse planned to purchase a house was inopportune, but not catastrophic.  Still, you both likely had to postpone your purchase for a couple of years.  Thus, the possibility that a market downturn will destabilize an entire financial plan just because it occurred at the beginning rather than later on in the plan’s timeline is called “sequence of return” risk.

 

You can imagine, then, how sequence of return risk could have a devastatingly large impact on a very large, very long-term goal such as making it through retirement disability, covering an extended period of disability or long-term care, or funding a special needs trust.  Let’s say you and your financial planner have calculated that you will need $1.75 million to fund your retirement with a comfortable margin of error.  In January of 2003, when you are 60 years old, you have $1 million in your 401(k).  You expect to work until age 65 and continue to contribute $18,000/year to the account until then.  By December 2007, you have $1.8 million in the account, comfortably ahead of what you need.  You coworkers plan a cheerful retirement party for you.  One of your subordinates thanks you for the training that will allow her/him to step up into your job.  You and your spouse have booked a cruise for the next summer to celebrate.  By June, your portfolio has dropped to $1.7 million, but you figure that’s nothing to worry about.  It’s just a 10% decline, right?  You go on the cruise anyway, expecting a rebound when you get back.  Instead, by the end of the year, your retirement account has dropped nearly 35% and is now just over $1 million.  You run the numbers again and realize you are going to have to cut all expenses significantly if you don’t want your retirement fund to run out before you do, and now you’re regretting that cruise.

 

My son cannot control which team he faces in Little League or whether the obstacles he finds the most challenging will come earlier or later in his parkour run.  What he can do is train hard and across many skills so that he and his team are best prepared to weather adverse circumstances.  You cannot forecast or avoid sequence of return risk, but there are steps you can take to mitigate it, which is the subject of our next blog (coming soon).

 

 

 

 

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