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As you may recall, sequence risk is the risk of receiving lower or negative returns early in a period when withdrawals are made from an individual’s underlying investments. We have examined two different scenarios so far: retirees who make periodic withdrawals and retirees who do not touch their initial deposit whatsoever. The first scenario is definitely affected by sequence risk, while the second is not.
There is a third but hardly considered scenario – what happens when you are constantly pumping in funds to a particular investment? Will sequence risk matter then? In this article, we will explore what sequence risk looks like for a young adult who is saving for retirement, while examining its complicated relationship to a traditional investment strategy – dollar cost averaging (DCA). These insights will let us know how to manage sequence risk and DCA during retirement.
The first person, Mr. Goforth started with zero savings in the year 1988 but landed a cushy job in an investment bank. From 1989, he saves $60,000 at the beginning of every year which is invested in the S&P500 and managed to do so for 20 years. In 1990, the starting balance of $60,000 shrunk by -3.06% to become $134,629. At the end of 20 years, he ended up with a total of $2.17 million. Not a bad result.
Ms. Gostan had similar circumstances to Goforth. She also graduated in 1988 with zero savings, but found a job in a prestigious consulting firm, and managed to save $60,000 every year for 20 years. The key difference is that she invested in the Reverse S&P500 index which has the reversed returns to the S&P500 index.
Surprisingly, she ended up much better off than Goforth, managing to accumulate $5.26 million at the end of 20 years, which is $3 million more than Goforth. We see clearly from these examples below that sequence of returns matters to a portfolio which is in the accumulation phase. This is due to the role that dollar cost averaging plays when we talk about sequence risk.
Dollar Cost Averaging
Dollar-cost averaging describes the technique of buying a fixed dollar amount of any investment on a regular schedule. It is usually applied to unit trusts because it is possible to purchase fractional units. This is the same reason why this strategy is nearly impossible to implement for shares – shares are usually sold in lots. The end result of following such an investing algorithm is that the investor purchases more shares when prices are low and fewer shares when prices are high.
The application of DCA analytic methods in evaluating sequence risk leads us into another insight as to how sequence risk works. Let’s examine this for Goforth in the table below.
We can use the same analysis for Gostan, as calculated in the table below.
For Goforth, the average price of the S&P500 index over the 20 years was $418.65. Through buying a fixed amount every year, he managed to get his units at an average cost of $275.44. At the end of 20 years, Goforth has 4,357 units of the S&P which is worth $2,171,955.
For Gostan, the average price of the Reversed S&P500 index over the 20 years was $161.07. Through buying a fixed amount every year, she managed to get her units at an average cost of $113.67. At the end of 20 years, Gostan has 10,557 units of the S&P which is worth $5,262,972.
Regardless of market conditions, you can see that DCA allows both investors to get the units of their respective investments at a discount. Gostan got an overall better discount in this case, but we know that in general, DCA allows all investors to easily buy units at a discount compared to the average price over the period.
How DCA Can Ruin a Retiree’s Savings
In the accumulation phase, following DCA will help investors reap the benefits of diversification across time by buying more units when the prices are low, ultimately ensuring the investor gets all the units at a better price than the average price. However, in the retirement phase, following DCA principles blindly will hurt the retiree as it means that the retiree will sell fewer units when prices are high, and more units when prices are low.
If the retiree sells more units when prices are higher, that would mean a more turbulent cash flow distribution pattern but also a higher rate of returns. This strategy would suggest that when times are good, the retiree can afford to withdraw more (sell), and when times are bad the retiree should tighten his belt and withdraw less (keep) accordingly.
This feast-and-famine approach to structuring retirement pay-outs may sound ludicrous, it has a sound rational basis as described in the above examples. When you think about it, there is a parallel between this approach and how people usually plan their expenses. Most people spend more when times are good and become thriftier when times are bad, so it makes sense that this same principle can also be applied to the theory above.