Sequence of Returns Risk - It's Real!
Finally, I managed to prioritise writing a post that isn't a monthly update. It possibly may have something to do with the global economy collapsing around my ears and my net worth shrinking every day for what feels like months now.
It's times like this in early retirement that regardless of the fact we had enough money to last a lifetime just a few months ago, now we don't. Well let me clarify that, we don't if the stock market never recovers, we never do another bit of side hustling in our lives and we carry on living at the pace we have been for the last couple of years.
All of those things happening simultaneously is not only fairly unlikely, it's almost impossible. But I'm not going to lie, when things are going this horrendously (and they're pretty dang bad at the moment) and there is little light at the end of what is likely to be a couple of years long tunnel, its fairly "human" to start putting a bit of extra thinking time into the future and what options we have. It's time to think about what contingencies we can put in place.
I guess it's no different to the times when we both worked in corporate. There would be a company restructuring project. In the industry we worked in, this was a regular occurrence and was usually triggered by one of two things:
The first was that the CEO had been fired in the last restructure, the new guy had come in, taken one look at the place and announced that the last guy didn't know what he was doing and that the company needed to be completely restructured and made more "efficient" by cutting hundreds of jobs.
The second was after that guy had gotten rid of a large portion of people who knew how the business actually worked, because getting rid of them gave the biggest cost savings (or they were willing to leave), the business would start to fall apart because there were less people and a lot less that new what they were doing. So said "Genius" would double-down and do another re-structure to save his own skin (which never worked) and was soon clearing his desk, returning the keys for his company Porsche and collecting his Golden Goodbye cheque but only after another bunch of colleagues found themselves jobless.
I lost count of how many restructures I went through but it must have been on average 1 every 2 years of my career and whilst I was never made redundant (maybe I wasn't one of the ones who knew how the business works!), every time it happened, I would review our finances, spending, investments and figure out how long I would have to find a job before we ran out of money if I did get the chop.
See, same thing as now in retirement, just I have years before I would need to get a job instead of months
Which sort of ish leads us into the concept of FIRE (Financial Independence Retire Early) and the concept known as Sequence Of Returns Risk.
What is it?
Well it occurs when you have saved up to your magic number (300 times your monthly expenses) and you duly quit your job and then within the first few months or years there's a major event that wipes out a bunch of your retirement pot
Specimen no.1 - Mr & Mrs H!
You see the traditional FIRE calculation is simply to save to your magic number and then live on 4% per year and invest in something as safe as you can that will give you a 5% + Inflation return and based on history, there is almost (note almost) certainty that your money will last forever regardless of when you pop off this mortal coil.
The problem is that whilst history had lot of stock market crashes, natural disasters and a few pandemics, FIRE assumes everything happens as an average so you would make some returns, there'd be ups and downs and over time the whole thing sort of works out and all is rosy in the garden..... right?
If something very bad happens in the early years, this is amplified into the future and affects every part of the calculation until there is a converse event to even things out. So basically, if you have a bear market, you quickly need a bull market to return the equilibrium. Hopefully that makes sense.
Let me give you a very basic example. If you had pushed the button on your magic number in 2007 by the end of that year when the great recession hit, your life savings would decline by around 20% in year 1. lets say inflation was at 1% and your investment pot was $1m. By the end of year 1, instead of having $1.06m you would have just $0.8m. This would mean you would have to try and reduce your living expenses by 26% to compensate and if you couldn't do that, it would take years of over performance to get back on track or you would somehow need to make up the shortfall through hustling or...shock horror...getting an actual job!
This is sequence of returns risk, the better your investments do at the start of your retirement, the less risk you have. If they underperform in the early days, it take twice as much effort to get them back on track.
Another huge factor of SoRR is if you're living off your savings, these are generally invested primarily in the stock market. And what happens when the stock market crashes? prices go down. And what happens when you sell at a low price? You make losses.
I always say that it's only a loss when you sell it but if you HAVE to sell during a stock market crash, you're not only realising the loss, you're kissing the future growth or recovery of that investment goodbye. Do that enough times, and you better be buying the job ads paper.
So how do you protect yourself against Sequence of Returns Risk? Well your options are somewhat limited:
Don't retire until your sure there's not going to be a crash - Impossible, once the crash happens, you won't have the choice to retire as your pot will have shrunk. Plus, nobody can predict the market and you'll end up waiting forever.
Don't invest in investments that are affected in a crash - There's logic in there somewhere but generally to get inflation+5% you have two reasonable choices, equity and property, both are based on the economy and therefore are equally affected by an economic downturn
Keep an emergency fund in cash to see you through a crisis - You should be doing this even if you're not retired. How much is difficult; not enough and you'll still have issues, too much and you're leaving investment returns on the table. 1 year of living expenses seems to be a reasonable rule of thumb
Get a side hustle to take your reliance off of your investments - This makes a lot of sense, if you can dial up the hustling in times of trouble, you can use less of your savings and even perhaps generate some free cashflow to invest in the bargains that can be had during a recession.
The truth is that it's kind of bits of all of the above, but doing nothing and not having a plan is just dumb, just think about the last few years, the current impending recession is due to....(deep breath)...A global pandemic, the great resignation, Russia invading Ukraine, Donald Trump printing cash like it's never been printed before, the cost of vaccinating the globe for free, some pretty mammoth natural disasters caused by our changing weather patterns and the need to give billions of people actual free cash handouts to prevent a humanitarian crisis.
And that's just in the last couple of years, what did ya think wuz gonna happen next?
So plan you must if you want a stress free, long and happy retirement. Sequence of Returns Risk shouldn't stop you retiring, and arguably, if you can afford it, now (or when we start to crawl out of this hole) wouldn't be the worst of times.
To help you with your thinking here's my basic, but in my opinion, fairly cunning strategy:
Invest a decent percentage of cash in Alternative Investments like Solar, Farming & Cattle - There's plenty of these opportunities about now but being in South Africa, Solar is a real winner. It pays returns of 10-12% in rental income over 20 years and it doesn't give a hoot about the economy, if the sun is shining, the electricity is produced and whilst there may be some fluctuation related to a recession (e.g. bad debt or low consumption) its a good reliable income. I'm trying to build up a portfolio that offsets our living expenses then SoRR is effectively removed.
Get a side hustle you can turn the volume up on - I'm fortunate enough to have found a side hustle (consulting) that means I don't have to work lots to make a decent wage. I don't advertise and I get enough work to offset living costs whilst staying at around 2 days per week. If I tried really hard, I could probably make myself busy, unhappy, but busy. The big difference between hustling and a proper job is my consulting assignments have end dates, plus I can say no if I don't want the work.
Keep 3 years of "Liquid" investments. Now this isn't cash, I prefer a slightly more high risk approach so where many people go with an 80/20 or 90/10 equity to bond (basically cash) ratio, I go 100/0 because of the solar investments. I do however keep at least 3 years of living expenses in instantly accessible investments e.g. they are not in RA, Pensions, Solar, locked in or time sensitive investments, they're generally in TFSA, Share dealing portfolios or low cost index tracking ETFs. I spread them across a broad portfolio so that as my last line of defence, if I have to sell some in a crisis, I can start with the ones in profit and work backwards.
And that's kind of it, offset living expenses with recession proof investments, work more when things are tight and have some money that can be accessed in less than a week if it's required.
If you follow the FIRE community and have read some of the more popular stuff from Mr Money Moustache or the Mad Fientist you would already know that the most important thing during a stock market crash or similar is simply.........................DO NOT SELL!
This may sound obvious and it's at this point a few months into a downward spiral that your mind inevitably reminds you that "If you'd sold your portfolio 3 months ago when this started, you could have bought back in now at 30% less".
Your mind is an asshole!
Hindsight is always 20/20 so don't listen to yourself with that nonsense, it has been proven time and again that timing the market is close to impossible and that if you miss the few days where there are massive jumps in the market (usually straight after a big fall) you will make less returns in the long run than having not sold in the first place. Now this is all very easy to say but the temptation to cut losses can be overwhelming so my strategy when things are going really bad is basically to stop looking at it. it will make you unhappy and who wants to be unhappy! It will recover, it always has.
I guess my final point on this subject is you will quickly learn how greedy you have been during a crash. It is the riskier, more high returning, flying by the seat of your pants investments that go down the most. Its logical really, they go up the most when things are good and come down the most when things are bad. A great example of this is my thematic ETF's. I'm invested in everything from electric cars to bio-genetics to 3D printing. During the pandemic, some of these ETF's provided returns of more than 100%. Guess what, they're now back down 50% lower than the price I bought them!
This is why you need to know what return you need and build a plan to get it with the least fuss and risk. I need 9.5% annually for our money to last forever. I aim for 12% (because I would like to increase our lifestyle spending a bit on holidays and a new car now and again) but yet I still have some investment that give 30% or even more. Why? pure greed. When things are going well, you forget there will always, and I mean always a counteracting downturn at some point. My strategy to combat that is that most of our cash in equities is in Low Cost Passive Index Tracking ETFs, more precisely low cost S&P 500 ETFs. These would give around 10-12% annually over the long term and won't fluctuate too wildly over that period. There simply great, but a more boring investment, you will struggle to find!
So to combat that, I do keep about 5% of our net worth for my crazy, lottery style investing that may just make us super rich and feeds my soul with the adrenaline only a 10 bagger investment can provide! The fact is, when, and it's only a matter of time, I do lose it all, at least the other 95% will have been taking care of the real investing.
Hopefully this has been useful, Sequence of Returns Risk can be much more complicated than this but if you're like me, you just want to understand the basics and that's what I set out to do, let me know in the comments if I pulled it off.
Until next time, keep living.