Tag Archives: sequence of returns

Does $97,000 Matter To You?

The S&P 500, including dividends, has produced a meager 4.86% annualized return for the 19-year period since 2000. That return has beaten inflation, but I call it meager because it’s not the 10% or so that many stock brokers, financial advisors, and market historians have taught much of the public to expect for such a long period of time. The return is way below the market’s long term average, even if our starting point is a bit arbitrary and convenient (the start of the technology stock meltdown).

But there is another lesson from the past 19 years besides subpar annualized returns. Those returns are radically bifurcated or back-loaded. In other words, they have accumulated recently or in the second half of the nearly two-decade period, not the first. And that means people in the age range of, say, 45-55, who have been investing by contributing steadily to work-sponsored savings plans like 401(k)s and 403(b)s for the past couple of decades, have been the beneficiaries of an amazing sequence of returns. It also means they may be unprepared for a less beneficial sequence in the future.

A way to illustrate this point is to compare a $95,000 lump sum investment in the S&P 500 TR Index in 2000 to a series of 19 $5,000 annual investments from 2000 through 2018. Amazingly, the final dollar value of the periodic investments nearly equals the dollar value of the initial large lump sum.

If the compounding is steady a large lump sum should outstrip periodic contributions because only a few of the contributions are getting the benefit of compounding for a long time. Only if the compounding is completely lop-sided, with positive returns occurring overwhelmingly in later years (which is what has happened), should these investments be nearly at the same dollar level. Another way of saying this is that, assuming reasonably even compounding, you should always want to invest a large lump sum immediately rather than dribble money into an investment over time. But the sequence of compounding over the last two decades has been anything but even or steady.

Volatility doesn’t matter for a one-time, lump sum investment. It makes no difference to the final amount when, over the investment period, the returns arrive; the annualized return will tell you what you have at the end. But when you get the returns matters a lot in cases of periodic contributions or withdrawals. When you’re saving periodically, you want the big returns, if possible, after you’ve accumulated some money. And you’d like to get the inevitable bad years out of the way in the beginning of a periodic saving or investment period when you don’t have a lot invested. That’s exactly how it’s worked out for middle aged people today who have been lucky enough to work steadily and earn enough to save periodically for the past two decades. The bad years came early when very little was at stake, and the good years came much later when much more was at stake.

To illustrate the importance of sequence of returns further, the chart below repeats the first chart with an additional line showing contributions made in reverse chronological order (2018-2000). Clearly, getting the big returns in the beginning, and poor returns at the end of a contribution period matters a lot for the final result. In the reverse chronological order scenario, the amount of final savings decreased roughly $97,000 (or 43%), from around $221,000 to around $124,000.

If investors were also able to ramp up their savings in the second decade, when returns were much higher, that’s worked out even worse for them in the reverse chronological scenario and better for them in the chronological scenario. Of course, it could also work out badly in the future if the larger contributions are buying stocks that, in retrospect, look like they might have been overpriced. Time will tell.

Last, it’s likely that those doing periodic investing haven’t realized how lucky they are in taking their lumps early and reaping benefits later. The poor overall or annualized return of the market over the full 19 years is less apparent to them. It also might not be apparent to them how quickly their luck can change, and that losses would matter a lot now that they have much more money saved. The poor returns of their early investing years could re-materialize, and that would be much worse for them now than it was when they first started saving money.

Target date funds might provide some protection to middle-aged investors in that they are surely less allocated to stocks for someone who’s 45, 50, or 55 than they were when the person was 25 or 30. But are they as conservative as they should be given today’s valuations, which the boffo returns of the past decade have produced?

Many financial pundits and advisors say you should just try to control the things you can. As an investor, that means the rate of savings, fees, and little else. You can’t know what your sequence of returns might be, according to the conventional advice. Sometimes you’ll get lucky, and sometimes you won’t; either way, just keep investing in an allocation driven by age and distance to retirement. Maybe that’s true in the end, but if you’re not wondering about how lucky the past long sequence has been for middle-aged savers and whether the next one will be as favorable to them, now that they have more at stake than they did 15-20 years ago, you might not be thinking hard enough. Even if you make no moves in your portfolio or investment strategy, you should probably be girding yourself emotionally for a less benign environment.

Is Your Target-Date Fund Too Risky?

If you’re planning to retire in or around 2020, and you have most or all of your assets in a target date fund, is that fund too risky? It might be given current stock market valuations.

I recently published an article on how various allocations served a hypothetical investor retiring in 2000. Any backtest begun that year would admittedly be unflattering to stock exposure, but retirees must think in worst-case scenarios because they are at risk of running out of money. And stocks may not be much cheaper now than they were in 2000.

In that article, I used the following chart to show how each hypothetical portfolio performed using the so-called 4% retirement rule, whereby the retiree withdraws 4% from his account in the first year of retirement, and boosts whatever the dollar value of that initial withdrawal by 4% each year thereafter.

It turned out that a pure stock portfolio couldn’t withstand the 4% rule given the amount of declines in two bear markets – from 2000 through 2002 and in the 2008-early 2009 period. The original $500,000 would have declined to a little more than $100,000 in the 18 year period. A balanced portfolio did much better; it would be down to a little more than $400,000. A still more conservative portfolio – 30% stocks and 70% bonds – would have remained intact. In other words, the more bonds a portfolio had, the better it held up despite the fact that stocks outperformed bonds on a compounded annualized basis – 5.4% for stocks  versus 5.1% for bonds.

And now most 2020 retirement funds have more than 50% stock exposure, potentially setting up their investors for a bumpy ride and loss of capital. On our list of some of the largest funds with 2020 dates, only the American Funds offering and the JP Morgan entry have less than 50% stock exposure.

Stocks reached a Shiller PE (price relative to the past decade’s average real earnings) of 44 in 1999, and they are at 32 now. The 44 reading seems far away, but, besides that extravagant reading during the technology bubble, the metric has been over 30 only one other time – in 1929.

Moreover, the median stock, on a variety of valuation metrics, is more expensive now than it was in 2000. For example, GMO’s James Montier recently showed that the median price/sales ratio is higher now than it has been in any other time in history. During the technology craze, small cap value stocks and REITs, for example, were left for dead, and investors prowling for cheap stocks could buy them, and wait. They wound up delivering boffo returns for the next decade. From 2000 through 2009, when the S&P 500 Index delivered no return, the Russell 2000 Value Index delivered an 8.3% annualized return to investors. But now there are arguably no cheap parts of the market.

Valuation metrics aren’t crash predictors; they don’t tell you a crash will occur next week, next month, or next year. But it’s reasonable to anticipate that the higher valuation metrics go, the more likely a significant decline or significant volatility become. And big declines hurt retires withdrawing from their accounts dramatically.

It’s also true that foreign stocks are cheaper, but they’re not that cheap. GMO’s most recent asset class return forecast shows no region of the world is poised to deliver inflation-beating returns. That means target date funds may be putting their client assets unnecessarily at risk. In 2013, Jack Bogle argued that target date funds were too heavily weighted in bonds, potentially crimping investor returns. With a Shiller PE above thirty and bond yields creeping up, the opposite might be the case now.

Financial planner and author Michael Kitces has shown that the Shiller PE works well as a financial planning tool, indicating what future returns stocks might deliver over intermediate time frames — around 8-18 years. Though a bit short on details, Kitces argues that the metric can help retirees facing sequence of return risk by encouraging them to adjust their spending. But it’s unclear why the metric can’t influence gentle portfolio modifications as well. When the Shiller PE is over 30, the likelihood of robust returns — or even returns that can beat bonds, despite low yields — is diminished after all. Nobody should ditch all their stock exposure; markets can always surprise investors. But retirees face such a harsh outcome if their portfolios suffer big declines during the first decade of retirement that modest stock exposure — even less than 50% stock exposure — appears the most prudent course. Unfortunately, judging from their allocations, target date funds may not be aware of the risk they’re imposing on their shareholders.

Target date funds are allocated based on investors’ distance from their spending goals. Even setting aside the difficulty of the retirement spending goal, which run over years and decades, distance from goal shouldn’t be the only consideration in answering the allocation question. Target date funds should also consider valuation and sensitivity to volatility.

Retirees: The Importance Of “Sequence Of Return Risk”

Do stocks get less risky the longer you own them? Most financial advisors say Yes; if you’ve got the time, you should own stocks. That’s because although nobody knows what the stock market will do over any one-year period, the market seems to go up over time — and at a rate that has overcome inflation by around 6-7 percentage points. History shows the longer the time period, the higher the chance of producing a positive return. So it’s foolish to own stocks for a one-year period, but also foolish not to own them if you’ve got, say, a decade or longer as a time horizon.

The problem is that a 60-year old planning to retire in five years doesn’t have a long period of time anymore. The typical advisor and the entire financial services business will argue that this hypothetical person does indeed have a long period of time because he will likely not die at 65. That person’s assets must see him through what could be a 30-year retirement. And that’s why most target date funds continue to have significant stock exposure on the date of retirement. The Vanguard Target Retirement 2020 Fund, for example, has 52% of its portfolio is stocks currently, according to Morningstar.

But increased longevity isn’t the final argument regarding asset allocation in retirement either. Last night, my colleagues, Richard Rosso and Danny Ratliff, and I interviewed Professor Zvi Bodie of Boston University who argues that the “stocks for the long run” argument can be misleading. Bodie decried the significant stock exposure that target date funds have at retirement, and argued that investors aren’t guaranteed to earn long term stock market historical averages by increasing their time frames. (Bodie says the same thing in this interview\ starting at 2:10). Not every 10- or 20-year period produces returns well in excess of inflation. the “risk premium” that stock are supposed to deliver over other asset classes is sometimes absent altogether. That means if someone has saved enough money to generate the income they need in retirement, one runs the risk of ruining that retirement plan by holding an excessive amount of stocks, whose value can decline significantly. After all, we’ve had two periods over the last 18 years where stocks have declined by 50%. One of those “drawdowns” lasted over two years and one period lasted for a little over one year.

Even if stocks do outperform bonds, the volatility they impose on an investor drawing income from investments can be catastrophic. Below is a chart of three hypothetical retirement scenarios beginning in 2000 and running through 2017. They represent a $500,000 retirement savings account invested in different allocations from which a retiree spends 4% in the first year and grows the initial withdrawal amount by 4% each year thereafter (the so-called 4% retirement income rule). The different allocations are a 30%/70% mix of stocks and bonds, a 60%/40% mix and a 100% stocks portfolio. We use the S&P 500 Index, including dividends, to represent stocks and the Bloomberg Barclay’s U.S. Aggregate Bond Index to represent bonds.

Over this period of time, stocks delivered a 5.4% annualized return, while bonds delivered a 5.1% annualized return. But, although stocks beat bonds marginally, increasing a retiree’s exposure to them didn’t help. The most conservative portfolio was the only one that kept the retiree’s assets intact after distributions. A balanced portfolio eroded the assets and a 100% stock portfolio eroded the assets spectacularly, despite the slight outperformance of stocks on an compounded annualized basis.

This illustration displays “sequence of return risk” well. The better performing asset on a compounded annualized basis was too volatile to keep the retiree’s portfolio intact. Losses came at the beginning of the distribution period so that the combination of losses and distributions in the first few years depleted the portfolio to the extent that a stock market rebound couldn’t elevate it adequately again.

Of course, stocks often beat bonds more resoundingly than they did from 2000 through 2017, though, again, not always. The illustration picks an unusually bad period when the stock market suffered two massive declines. That tends to harm a portfolio in distribution considerably. But investors should think in terms of worst-case scenarios, not just long-term averages.

Furthermore, investors should take starting valuations into consideration when contemplating various scenarios and their likelihoods. While the Shiller PE (current price relative to the past decade’s average, real earnings), for example, is lousy at forecasting crashes and short term returns, it’s pretty good at forecasting the next decade’s worth of returns. And because it has this longer term forecasting ability, it can be useful to retirees as financial planner Michael Kitces shows (here and here).

Currently, the Shiller PE is elevated at 32. Its long term historical average is less than 17. Perhaps a “new normal” for the metric is 20 or even 22, since companies are more profitable now than they were in the past. But even a new normal doesn’t make stocks appear cheap or future returns robust. That means, with stock return prospects so low, investors embarking on retirement probably shouldn’t have more than half their assets in stocks, and many should consider having considerably fewer than half their assets in stocks. In other words, the typical target date fund allocation may not be appropriate for many retirees.