There are 720 possible paths with this strategy, too, but notice a big difference between this and the previous chart: all paths end up in the same place — $866,008 in our example. When you withdraw a constant percentage of remaining portfolio balance annually, you have no SOR risk. The ultimate portfolio value doesn’t depend on the order of market returns.
We can eliminate SOR risk to our portfolio’s terminal value by basing withdrawals on remaining portfolio balance, but this does not eliminate SOR risk from our portfolio payout. In fact, we cannot eliminate SOR risk from the payouts of any strategy that spends down a portfolio of stocks and bonds. We simply cannot expect to safely withdraw a constant amount from a volatile portfolio.
This brings me to what I believe to be a critical point: when you buy and hold, or buy or sell a constant percentage of your remaining portfolio balance periodically, you are gambling that stock prices will be higher in the future. That’s market risk.
But when you withdraw (or invest) constant dollar amounts periodically, or random dollar amounts, or changing percentages of remaining portfolio balance, you are placing a large side bet on which path those market returns will take to get there.
You’re adding a significant amount of risk to your investment, as can be seen by the single outcome for percentage withdrawals and a wide range of outcomes for constant dollar withdrawals. The constant dollar withdrawal policy had a range of outcomes of nearly $152,000 for a portfolio that started out with a million dollars.
We get compensated (over the long term) for taking market risk. Sequence of returns risk, however, is not market risk, but risk that an investor may add with her investment policy. The market cannot reward you for that risk. Investors with SOR risk add additional risk that is not diversifiable and with no expectation of additional reward.
What strategies escape sequence of returns risk? Many of the columns I have read recently suggest that the only way to avoid SOR risk is to avoid volatile assets like stocks, or at least to reduce your exposure to stocks to reduce SOR risk. Though that will certainly do it, that doesn’t appear to be the only way.
Buy and Hold is a special case of percentage withdrawal strategies where the percentage sold simply equals zero. There is no SOR risk. Though I have not done the math, I would expect Value Averaging to avoid SOR risk. As I have shown above, withdrawing a constant percentage of remaining portfolio balance has no SOR risk.
Dollar Cost Averaging and Safe Withdrawal Rate strategies are both exposed to SOR risk — they buy or sell constant dollar amounts — and perhaps that is why they underperform in most studies that compare strategies.
Lastly, the number of possible market return paths increases by a factorial every period. Given its source, you would expect SOR risk to be cumulative and to grow rapidly with the number of interim transactions, and it does. I ran a 30-year set of S&P 500 annual returns from 1983 to 2012 and found that the best and worst possible outcomes for a $1M investment and $45,000 annual withdrawals ranged from about $39,000 to $42,000 after ten years. After thirty years, the range grew to $50,000 to $200,000.
So, here are my take-away’s from this post.
Sequence of return risk comes from our investment policies, not from the market. It is the result of the uncertainty of prices at the interim buy/sell transactions after the initial investment. There is no SOR risk with Buy and Hold because there are no interim transactions. There is also no SOR risk when we buy or sell amounts based on remaining portfolio balance, as I showed algebraically in my last post.
SOR risk increases dramatically over longer time periods because there are far more interim transactions that introduce more price risk.
SOR risk cannot be diversified away, nor are we compensated for it.
Choosing an accumulation or spending strategy that introduces additional risk that is un-diversifiable and uncompensated cannot be an optimal approach in either phase.
There's more to Sequence of Return risk and it's going to take a few more posts to cover it. I hope you'll stick with me for the next post on this topic, Sequence of Returns Risk and Payouts.