This Past Week As A Micro Example Of Sequence Of Return Risk

rogernusbaum

We've explored the concept of sequence of return risk many times before and the panic of the last week gives a little of an idea in real time how it works and why mitigating it one way or another is prudent. The 12% decline of the previous week was a crash. The crash may or may not be over but declines that are that fast are crashes and there is no realistic way to avoid a crash. Bear markets like in 2008 and before that in 2000 and maybe even late 2018 tend to start slowly, they rollover for a period of months. Even in 2018, the market peaked in October of 2018 before the whoosh down in late December. In the current event, the market crashed from a high put in just a few days earlier.

Imagine that your retirement date is April 1st, 2020 and you were fully invested in a 60/40 portfolio, 60/40 being pretty reasonable. Would the roughly 7% you might be down (60% of 12% being 7.2%) be enough to cause you to considering delaying your retirement? There's no wrong answer there, this is sort of thing is up to the individual. What if the crash is not over and two weeks from now, the stock market is down 25% from it's peak? Would the then 15% decline (using the same math as above) cause you to consider delaying your retirement? There's still no wrong answer but you can appreciate that at some point, people relying on an investment portfolio to fund some portion of their retirement would consider a delay in this scenario due to market reasons, reasons related to the consequence of an adverse sequence of returns.

At the same time, life circumstances could be equally powerful in driving your desire to retire including health issues, your job no longer being available if you've previously announced a retirement date, hating your job, some sort of family consideration or anything else you might think of.

Regardless of whether the selling is over (probably not over but who knows) or this goes on to be as bad as the financial crisis (extremely, extremely unlikely), there is no question that the event will end at some point and then the market will work its way back to a new high, there's just no way to know how long that will take.

But market events like this can get in the way of life events, someone retired on December 31st, 2007 and probably endured a lot of stress. There are ways to mitigate, even if just partially, the consequence of an adverse sequence of returns. The simplest way is to raise some cash ahead of time. This is not market timing, it is more like life timing. You're 60, have enough for retirement now with a plan to retire at 62. At this point you should have some idea of what your retirement expenses might be in monthly terms.

How many months of expenses would you feel comfortable having set aside in cash in case something does go wrong in the market? There's no wrong answer but there are potential consequences to what you do. Is six months worth of cash need enough to allow the stock market to recover before starting to draw from the portfolio? For something like the financial crisis, no it wasn't but for something like the panic in late 2018 or the taper tantrum in 2013 it would have been enough.

Where there is no single answer that's correct for all circumstances, the solution boils down to truly understanding your risk tolerances and emotional triggers. This past week might serve as a reminder of these things for people. Paraphrasing myself from past blog posts, you don't want to find out that you had too much in equities after a crash.