This dynamic is referred to as sequence-of-returns risk, or "sequence risk," and it is a potent danger for retirees who are committed to pulling capital from their invested assets regardless of market conditions. The potential damage caused by sequence risk can be difficult to quantify because there are a lot of variables to consider, but this is a useful concept to evaluate the efficacy of strategies that can mitigate sequence risk.
Assuming the worst: building a "Super bear market"
We begin by simulating a "worst-case" bear market for different stock/ bond portfolios. We accomplish this by looking at the statistics from each of the seven post-war bear markets from our Bear market guidebook, and combining their worst characteristics—the largest and fastest drawdown and the longest and slowest recovery time—to produce a "super bear market" for each portfolio.
These "super bear markets" comprise three sections: the drawdown period, where the portfolio quickly goes from peak to trough; the plateau, where the portfolio stays at its trough value for months; and then the recovery period, where the portfolio endures a very slow-but-steady rally from the trough back to a new all-time high.
Next, to accentuate the potential sequence risk in the simulation, we assume that the bear market begins at the worst possible time: at the beginning of retirement. To create a baseline Bear Market Damage Index, we assume a 4% annual withdrawal rate (taken monthly), along with a 2% annual spending increase to approximate a rising cost of living due to inflation.
The Bear Market Damage Index
To calculate each portfolio's BMDI, we run a simulation of the portfolio's value after withdrawals up until the end of the longest-ever bear market window.
At this point, the portfolio would have recovered back to a new all-time high without spending, but the spending has significantly depleted the portfolio value and locked in bear market losses.
BMDI is calculated as the percentage of the portfolio's depletion, indexed to 100. For example, a USD 1 million all-equity portfolio would have experienced a 51% drawdown over the course of three months, and spent about 25 months at the plateau before beginning the 49-month climb back to a new all-time high, resulting in a "bear market window" (time from peak to peak) of 74 months.
An investor would have spent about USD 258,383 during this window, and without any capital set aside in a Liquidity strategy to meet cash flow needs, they would have locked in another USD 158,106 of losses due to sequence risk. Therefore, the BMDI for this portfolio is 42 (USD 1,000,000 starting value, minus the ending value of USD 583,511, divided by the USD 1,000,000 starting value, multiplied by 100). With a 74-month Liquidity strategy allocated at the beginning, the investor would have been able to avoid locking in any losses, resulting in a BMDI of just 26 (USD 1,000,000 starting value, minus the ending value of USD 741,617, divided by the USD 1,000,000 starting value, multiplied by 100).
Manage risk, but also opportunity cost
Of course, bear market risk is only one side of the coin. As we discuss in " The difference between pain and damage," taking too little risk can cause just as much damage as taking too much. For example, a Liquidity strategy does not need to be funded solely from the asset side of the balance sheet, and investors that are willing to borrow to meet some of their cash needs can manage bear market risk with less opportunity cost (foregone gains) during bull markets. Finding the right balance is crucial, so make sure your bear market plan considers both sides of the coin.
Main contributors - Justin Waring , Michael Crook
For more, see Introducing the Bear Market Damage Index, 8 August, 2019.
*Important disclaimer regarding the Liquidity. Longevity. Legacy. framework. Timeframes may vary. Strategies are subject to individual client goals, objectives and suitability. This approach is not a promise or guarantee that wealth, or any financial results, can or will be achieved.