You will be able to explain sequence of returns risk and name ways to reduce it.
Two friends stop working in the same month, each with S$1,000,000 invested in the same kind of portfolio, each planning to take out S$40,000 a year. Over the next ten years their portfolios earn exactly the same returns, just in a different order. One meets a crash in the first two years. The other meets it in the last two. At the end of the decade, one of them has about S$886,000 left and the other has about S$1,123,000.
Nothing about their plans was different. Only the timing of the bad years was. That gap has a name, and it is the biggest risk in the first years of any plan to live off investments.
Sequence of returns risk is the risk that poor returns arrive early in the years you are withdrawing, when they do the most damage. While you are still saving, the order of returns makes no difference to where you end up: a sum invested for ten years and left alone grows to the same figure whatever order the returns came in. Once you are taking money out, the order matters a lot.
The figures in the opening come from a made-up example, checked step by step. Both portfolios start at S$1,000,000. Each withdraws S$40,000 at the start of every year. The ten yearly returns, after inflation, are the same set: minus 20%, minus 10%, then 5%, 10%, 15%, 10%, 10%, 5%, 10% and 15%. Their simple average is 5% a year in both cases.
The first friend gets them in that order, with the falls first. After two years her portfolio is down to about S$655,000. The second friend gets them in reverse, with the falls last. After two years he is at about S$1,170,000. By year ten, she has about S$886,000 and he has about S$1,123,000, a difference of nearly S$240,000 from nothing but timing.
Without any withdrawals, both portfolios would have finished at the same figure, about S$1,537,000. The withdrawals are what make order matter.
When the portfolio falls in a year you are withdrawing, you have to sell more units to raise the same S$40,000, because each unit is worth less. Those units are gone. When prices recover, they are not there to recover with you.
This is what people mean by locking in losses. A fall on paper is not yet a loss you have taken. Selling to pay the bills turns it into one. A portfolio that has had to sell heavily at low prices has a smaller base to grow from for the rest of the plan, and the good years that follow cannot fully repair it.
Losses late in the plan matter less, partly because the portfolio has already done most of its work, and partly because there are fewer years left to fund.
This is also why the worst historical starting years drove Bengen's result in lesson 2.1. The retirees who struggled were mostly the ones who met a bad market, or a stretch of high inflation, near the start.
You cannot choose the order of returns. You can change how exposed you are to them.
The first way is a buffer. If you hold a few years of spending in cash, deposits or short-term government securities, you can pay the bills from the buffer in a bad year and leave your shares alone until they recover. Then you refill the buffer in better years. Module 6 sizes the buffer properly in lesson 6.3, The cash buffer that buys you time.
The second way is a spending rule. The retiree in Bengen's model raised spending for inflation every year, even straight after a crash. A simple rule changes that: after a year in which the portfolio fell, skip the inflation increase the following year. A stronger version also trims flexible spending by a set share until the portfolio recovers. Each one means selling fewer units at low prices.
Other options sit around the edges. Some people plan to do a little paid work in the first few years, so that a bad start can be met with income instead of sales. Some keep a lower withdrawal rate in the early years and raise it later if things go well. Each of these makes the early years less dependent on luck.
A spending rule only works if you follow it when markets are falling, which is the moment when it is hardest to think clearly. The news is bad, the portfolio is down, and the urge is either to panic and sell everything or to pretend nothing has happened.
So write the rule now. Be specific about what counts as a bad year, for example a fall of a certain size in the portfolio's value over twelve months. Then say exactly what you will cut: the inflation increase, a fixed share of flexible spending, a particular holiday. And say when you will go back to normal.
Priya, from module 1, has about S$15,500 of flexible spending in her made-up base. She could decide that after a year in which her portfolio falls by a large amount, she will skip the inflation increase and cut her travel budget in half until the portfolio is back to where it started. That is a rule she can act on without having to think under pressure.
Your rule will depend on your own flexible spending and how much of it you could give up for a year or two. Have your split from lesson 1.2 to hand when you write it.
Write the spending rule you would follow after a year in which your portfolio fell by a large amount.
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