If you plan to fund retirement by selling off assets from such a portfolio, it is vital that you understand what SOR risk is, its source, and how it impacts your finances after you retire. I won't repeat the first two points about definition and source here, so you might want to review my earlier posts before proceeding, but I do want to expand the discussion regarding the implications of SOR risk.
As I mentioned, SOR risk is a result of periodically buying or selling from a volatile portfolio of stocks and bonds, as retirees do who implement a systematic withdrawals (SW) strategy. They're going to sell stocks every year for perhaps 30 years or more and with no idea what future stock prices will be when they eventually sell. That uncertainty is SOR risk.
In contrast, if they bought the exact same portfolio and held it intact for thirty years, the sequence of returns would make no difference in the portfolio's terminal value, whatsoever.
SOR risk is also present in the accumulation or "saving" phase of financing retirement, but its impact appears to be less severe than during the spending phase and it is more controllable. We sell assets in retirement because we have an urgent need to spend the money, even if we are forced to accept a low price, but we can easily postpone purchasing stocks during the accumulation phase when prices are high by leaving our savings in cash for a while.
Selling a constant dollar amount every year exacerbates SOR risk because it means that we will sell more shares when prices are low, which is, of course, the opposite of what we would prefer. Selling a percentage of remaining portfolio balance every year instead would help us sell fewer shares when prices are lower, but would leave us with an unpredictable income stream. (I still think that is the preferable approach. When you have less wealth, you should spend less.)
Bonds held to maturity, annuities, pensions and Social Security benefits, on the other hand, are not subject to SOR risk. The portion of our retirement spending provided by those sources is not affected by stock market price variance. In fact, even bond funds that do not hold their bonds to maturity but have low volatility will have only a little SOR risk.
So, the first way that SOR risk impacts retirement finances is that it is only present when we buy or sell from a volatile portfolio. Retirees with little or no stock exposure will have little or no SOR risk. The second way it impacts retirement finances is that it has a greater impact during spending than during accumulation. A poor sequence of returns when we are saving reduces our accumulated wealth, but during the spending phase a poor sequence can take us out of the game entirely.
In finance, risk is often defined as the uncertainty of outcomes. Unlike the everyday connotation of the term "risk", uncertainty can be both good and bad. A risky portfolio of stocks and bonds has greater potential for both gains and losses than a less-risky portfolio. Risk is where we make our money on investments. Risk-free investments do well to cover inflation.
In the same sense, sequence of returns risk can leave you with more wealth or less wealth. The most wealth during the spending phase comes when a sequence of returns is ordered from the best return first to the lowest return last. The least wealth comes when that same sequence is ordered from worst return first to best last.
In the saving phase, the opposite is true. We want the best returns later in life when our portfolios are larger, and we mind losing money less when we are young and have little to lose.
SOR risk is completely unpredictable. Diversifying your stock assets won't reduce this risk and the market cannot compensate you for it. In that sense, it's a "bad risk". A good risk would be one that we can be compensated for taking.
Much is made, and rightly so, of the fact that big portfolio losses early in retirement can devastate your portfolio. Wade Pfau estimates that your returns in the first decade of retirement explain about 80% of portfolio survival for thirty years. I have seen simulated scenarios with correlations near 90%. This is a result of SOR risk and is a direct result of my previous statement that "the least wealth comes when that same sequence is ordered from worst return first to best last."
An important consequence of sequence of returns risk is that our terminal portfolio value, what we have remaining to leave to heirs, can be dramatically different even with the same portfolio returns.
Following is a scatter plot of terminal portfolio values (TPV) versus portfolio returns. I created this from a simulation of 10,000 scenarios of annually spending 4% of initial portfolio value for 30 years from a 50% stock portfolio with a geometric mean return of 5.6% and a standard deviation of 11%. Each blue dot on the chart represents a scenario's TPV when the average return equalled amounts along the x-axis. (I let the portfolio values run negative, even though your broker won't, because cutting off the portfolio values at zero graphically hides some information.)
Notice that the very bottom of the blue crescent area of terminal portfolio values drops below the zero portfolio value line (x-axis). In the following chart, I zoomed in on the area between 1% and 6%, where portfolios both succeed and fail.
If you look directly above 4%, for example, you will see that many portfolios had TPV's greater than zero and many showed negative TPV's even though they all experienced 4% average growth annually without spending.
Again, SOR risk results in a broad range of outcomes even with the same market return.
SOR risk can exacerbate other risks, as well.
Imagine that you are retired and have a mortgage, so you have foreclosure risk. If your mortgage payment is paid from the sales of stocks in your retirement savings portfolio, then a poor sequence of returns could jeopardize your ability to make those payments. Your home is now subject to a greater risk of foreclosure than if your entire mortgage were paid from pension benefits or an annuity, for example.
The last thing I want to point out about SOR risk in this post is that, as the chart above shows, some portfolios failed with a 6% portfolio return, while others funded thirty years with portfolio returns of only 1% or 2%. The former had a poor sequence of annual returns while the latter had a fortunate sequence.
So, those are eight things you need to know about sequence of returns risk (I italicized them), and here's one more.
If stock investing weren't risky enough, once we start spending from a portfolio and exposing ourselves to sequence of returns risk, our financial success in retirement is not solely a function of the rate of return we earn. It also depends on the sequence of returns. An SW portfolio can fail when average returns from the market do relatively well and survive when average market returns are relatively modest.
I'll pick up there in my next post.