Sequence of return risk is among the largest mistakes non-professionals and math-oriented investors make regarding personal financial planning.
These folks conflate AVERAGE investment returns with a annual, year over year, investment returns. And you just can't do that.
Let me explain. You look at the S&P 500 and see that it has averaged say 10% a year since 1926. Thus you think if you invest in the S&P500 you can safely withdraw 6% a year and you will still add 4% a year to your capital base.
$100,000 in the SP 500 allows you to withdraw $6,000 and the next year you have $104,000 in your account.
Using average returns over time, this actually makes sense.
But reality isn't 'average'. In reality, the SP 500 has years like 2000, 2001 and 2002 when it was down 9%, 11% and 22% respectively.
In this case, your $100,000 fell to $91,000 in 2000. Then you withdrew $6000 and now your investment was down to $85,000.
The following year, your $85,000 fell 11% to be down to $75, 650 and once you withdrew your $6,000 you only had around $69,000 left.
In 2002, the portfolio fell another 22%, putting you down to $54,000 and when you withdrew $6,000 you were left with less than HALF of what you started with 3 short years earlier.
Your $6,000 a year withdrawals are no longer equal to 6% like it was initially, but now you're withdrawing almost 13% a year from your portfolio!
No amount of growth from here on out is going to save you. You WILL run out of money!
That is sequence of return risk. Even though the market averaged 10% a year, or whatever it was, in any year you could lose your shirt and thus your distribution percentage is WAY higher than can be sustained.
This is where the 4% rule becomes important to understand. Because it is the 4% rule that takes into consideration sequence of return risk.
Second part of this video, I talk about how interest rates work vs. total return on bonds and bond funds.
Interest rates are simply what you get for investing your money into a bond TODAY. I buy a bond today that has a an interest rate(or coupon) of 6% for $100,000.
I will then receive $6,000 annually until either the bond matures and I get my $100,000 back. The issuer goes bankrupt, in which case I lose everything. Or the bond is called, kind of like a corporate debt refinance, and I receive the $100,000 back.
Now let's say interest rates go down across the economy. That same issuer of the bond I hold now issues new bonds but this time they're only paying 5%.
The new bonds also cost $100,000. So, if I were to buy a new bond for $100,000 I'd only get $5,000 a year in interest. Which do you think is more valueable? A bond paying $5,000 or a bond paying $6,000?
Well, the $6,000 bond is of course.
This means my $6,000 a year bond will command a higher price than the bond that only pays $5,000.
But remember I paid $100,000 for each bond. So, in this case, my 6% bond could be sold for MORE than $100,000 because an investor would be willing to pay a premium on that bond in order to get more interest.
The investor says something like, "I can pay $100,000 to get $5,000 a year interest, or I can pay $105,000 to get $6,000 a year interest."
(There is a mathematical formula to determine the actual value for the 6% bond by the way.)
Let's say I sell my 6% bond for $105,000. Now I've made $5,000 in capital gain AND $6,000 in bond interest for a total return of 11%.
Whereas if I didn't sell the bond, I'd just get interest of 6%. And that is the difference between the two.
But, critical to remember, my 11% total return is only temporary. I can not get 11% total return again. The only reason I was able to pocket that extra $5k was because interest rates went down. They can only go down so far
In fact, when they start going up again, my 5% will LOSE value because it's only paying $5,000 when other bonds are paying $6,000.
In this case, I'd take a LOSS in order to sell that bond and that loss would offset the capital gain I had before.
Finally, at the end of the day, the ONLY return one can correctly assume he will earn on bonds is the interest rate he receives on the day he bought the bond.
All other returns, that go into the total return calculation are only temporary.
You can not rely on total return of bonds to estimate your potential for a bond investment. You should ONLY use interest rate at the time you purchased.
For more information on topics like this, visit my website at www.heritagewealthplanning.com
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