I'm writing this late February 2022, 1 day after Russian president Putin has ordered his military troops to attack Ukraine from different sides.
No worries, I won't get political.
2 years ago, the world was attacked – literally – virally, by SARS-CoV-2, its different variants, and what is now known as the Covid-19 pandemic.
Both of these have had an impact on the economy, on the market, and thus, on your early retirement. In some way. 2022 will also be known for a year of globally high inflation rates.
Whereas the S&P500 recorded astronomical gains during the pandemic, it's decreasing in value YTD (year-to-date).
So, let's talk about this. How do world events that impact the stock market impact your early retirement plans?
PS: I'm not an economist, financial planner/analyst, or anything like that. There's a full disclaimer at the end of this post, but suffice to say that I'm just a “regular guy”. A lot of other people go more in-depth on sequencing of return risk, which will also be linked throughout and at the end of this post.
What is Sequencing of Return Risk?
The concept of sequencing of return risk (I'll use sequence risk from now on) is the risk that an investor will experience negative portfolio returns late in their working career and/or early in retirement.
This is heavily influenced by when (or the time that) an individual like yourself may start to make withdrawals from your investment portfolio, which will most likely consist of stocks and bonds.
For example, someone who started withdrawing from their investment portfolio on January 2022 may be kicking themselves in the head now – or, possibly, will soon – because their investment portfolio is now decreased (1) by the made withdrawal, and (2) the decrease of the overall market value.
S&P 500 Total Returns (1990 – 2009)
I'm going to use illustrations from this YouTube explainer video on “What is Sequence of Return Risk?'.
This scenario is looking at the returns, both actual and on average, of the S&P 500 without making any withdrawals from 1990 – 2009.
Starting value: $1,000,000 Ending value: $4,842,414 Total Returns: $3,842,414
Nice returns, right?
We don't see sequence risk doing its thing yet in this example.
This scenario is also looking at the actual and average returns of the S&P 500, during the same timeframe (1990 – 2009) but with making annual withdrawals of $50,000.
Starting value: $1,000,000 Ending value: $2,797,350 Total Returns: $1,797,350
Still nice returns, right? But it's already a difference of 53.22% compared to the previous scenario.
In this example, we do already see sequence risk at play. It just happens that, in this case, it works out positively.
How Time Impacts Sequence Risk
Remember, that sequence risk is the risk of experiencing negative portfolio returns during someone's early retirement. In other words, running out of money. We don't want that, right?
And remember that this risk is heavily dependent on time, or when you make withdrawals. In a bear, or a bull market. Those can in turn be influenced by global events, like the pandemic, or what's currently going on between Russia and Ukraine.
In the example above (1990 – 2009), the first few years everything was going smoothly. The market, as it does on average, went up.
Then, the dotcom bubble started growing and we can see that from 1996 – 1999 the market abnormally grew in value.
The bubble eventually burst in 1999 and you can see some abnormal declines from 2000 – 2002.
But… that $1,000,000 had already grown at such a rate that it benefited both from the average returns of the market, as well as the significant growth of market value before the dotcom bubble burst that it, essentially, could take the losses in the years that followed – including the global financial crisis of 2008.
If you look at the returns of the S&P 500 (displayed here in the video, you can see that, aside from the -3.10% in 1990, each year saw some good growth.
Until the bubble burst.
In the next example, we'll be looking at the S&P 500 but from 2000 – 2019. Same length of time, but very different results. You'll see why.
S&P 500 Total Returns (2000 – 2019)
This scenario is looking at the returns, both actual and on average, of the S&P 500 without making any withdrawals from 2000 – 2019.
Starting value: $1,000,000 Ending value: $3,241,326 Total Returns: $2,241,326
Again, some nice returns. But this doesn't show sequence risk. What if you started withdrawing $50,000 annually off of this portfolio during this timeframe?
This scenario is also looking at the actual and average returns of the S&P 500, during the same timeframe (2000 – 2019) but with making annual withdrawals of $50,000.
Starting value: $1,000,000 Ending value: $271,317 Total Returns: –$728,683
Suffice to say that your investment portfolio wouldn't be able to take this hit, and that you will probably run out of money during your (early) retirement.
Why is this?
Whereas in the previous example of sequence risk (making withdrawals during 1990 – 2009) where the significant decreases of the market happened later on in those 19 years, in this example, they happened very early on.
Kind of like kicking the portfolio when it's already down.
What Can You Do Against Sequencing of Return Risk?
There is no sure-fire way to completely eliminate sequence risk of your investment portfolio, if it contains stocks and bonds.
Run far away from anybody who tells you otherwise.
Because, to be absolutely sure that you're not putting your portfolio at risk, you'd need to know what the market is going to do.
And nobody can predict the market.
Risk Mitigation of Sequencing of Return Risk
While there's no way to reduce the risk completely to 0%, there are ways that you can get closer to it.
Cash Is King?
In this case, it absolutely can be. Having a liquid asset, such as cash, available to you when major global events that are completely out of your control are happening can be a way for you to not withdraw for a year, or withdraw significantly less.
This brings me to my second point.
Be Flexible with Your Savings Withdrawal Rate
I've mentioned the Rule of 4% before on this blog. It's a general guideline a lot of us use to calculate your financial freedom number and has a big influence on what your eventual FI number will be.
But, do not use it as a strict rule! Especially when trying to simply mitigate your sequence risk. Maybe you can withdraw less in a given year, and bridge the rest with cash on hand.
When explaining what kinds of investment portfolios are at risk of sequence risk, I tried to keep the nuance intact of adding “an investment portfolio of stocks and bonds.”
Because your investment portfolio can also include other assets, such as commodities, or real estate. Some won't be (as directly) influenced by major global events, but can still either provide you with another income source during your retirement, or be something you can sell.
Now that I've mentioned income sources…
Multiple Streams of Income
If your livelihood is entirely dependent on your investment portfolio of stocks and bonds, it's like bringing a knife to a gun fight when it comes to your sequence risk.
That's why you need additional streams of income.
This can be pension checks, CD contracts, or simple businesses that you have some ownership in and pay out nice profits to you.
Your additional revenue stream doesn't need to be this 6- or 7-figure income generator. It can be something that brings in a nice extra $60,000 annually.
This can even help you eventually withdraw less from your investment portfolio.
Your business is also an asset that you can eventually sell for a multiple.
In fact, I'm such a big disciple of multiple streams of revenue that I also write about it on this blog.
Additionally, if you're still in your accumulating phase of early retirement (building your investment portfolio), having a few consistent streams of income can also be the reason why you'd need to withdraw only, for example, $30,000 from your investment portfolio, because you know the other $30,000 is coming from these other streams.
This can severely cut down the time it'll take you to reach financial freedom. A good business model to consider is affiliate marketing.
When Should You Care about Sequencing of Return Risk?
If you're in the accumulating phase of your early retirement journey aka building your investment portfolio and you know early retirement is at least 7 – 8 years away…no.
Don't change any of your strategies, objectives, or goals.
In fact, this may be a great time for you to invest the same amount you have been on a monthly basis but pick up more shares. From a pure stock market perspective AND you're in that accumulating phase, “everything is on sale”.
How are you handling major global events and the impact they have on the market? Are you changing anything in terms of strategy or objectives?
Jack Bogle deserves his own embed:
What is Sequence of Return Risk?
Investing 101 – Sequence of Return Risk Explained
What is Sequence Risk? (Explained) | 4 Ways to Manage Sequence of Returns Risk in Retirement
Disclaimer: I am in no way a certified expert. I have no formal financial education. I am not a financial advisor, portfolio manager, or accountant. This is not financial advice, investing advice, or tax advice. The information on this website is for informational and recreational purposes only.
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