Sequence of Returns: the Biggest Risk to Financial Independence & a Successful Retirement

Sequence of Returns: The Biggest Risk to Financial Independence & Successful Retirement

When you think about your retirement & financial independence, what keeps you up at night?  Is it the possibility that a market crash depletes your nest egg?  Is it inflation?  What about the cost of health care, or living too long and running out of money?

These are all common concerns I hear from people approaching their leap into financial independence.

Every now and then someone will ask me what they should be concerned about.  “What would you be concerned about if you were in my shoes?  What are my biggest risks?”

 

Average Returns & Volatility

Most of us approach retirement planning with expectations about the average returns we’ll see throughout retirement.  You’ve probably heard (maybe even from me) that the S&P 500 averages between 7.5% and 9% in annual returns – depending on the exact data set and who you talk to.  Over a 30+ year retirement, if we were to invest only in the S&P 500, we could expect an average annual return between 7.5% and 9%.  I’m confident this is true, based on the last 150 or so years of historical data in the financial markets.

As you know, this doesn’t mean that the stock market will gain 7.5% each and every year.  There will be years like 2001 and 2009 where the market falls 25%-30%.  There will also be years where it gains 25% or more.  The markets are volatileBut on average, the S&P 500 will see somewhere between 7.5% and 9% returns per year.

One of the statistical measures of volatility is called standard deviation, which is used to measure just how volatile a data set is around an average.  Since 1926, the standard deviation of the S&P 500 is about 18.5%.

Now, the image below is something you’ve seen before.  It’s a bell curve based on a normal distribution.  The simple explanation of a a normal distribution is that the results occur randomly around the mean.  In a normal distribution:

  • 68.2% of the results will fall within one standard deviation of the mean
  • 95.4% of the results will fall within two standard deviations of the mean
  • 99.6% of the results will fall within three standard deviations of the mean
  • 99.8% of the results will fall within four standard deviations of the mean

 

Sequence of Returns: The Biggest Risk to Financial Independence & Successful Retirement

What does this mean for the S&P 500?  If the S&P 500 is normally distributed and resembles a typical bell curve, annual returns will fall between:

  • -11% and 26.5% 68.2% of the time (7.5% – 18.5% & 7.5% + 18.5%)
  • -29.5% and 45% 95.4% of the time
  • -48% and 63.5% 99.6% of the time

I should note that many have argued the returns of the S&P 500 are not normally distributed, including William Egan and Nassim Nicholas Taleb.  And for the most part I don’t disagree with them.  This argument is beside the point of this post though, so for this discussion and the following examples we’ll assume a normal distribution fits the S&P 500 just fine.

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