A Look At Sequence Of Return Risk With Examples And Simulations

Table of contents

• What is Sequence of Return Risk
• An ideal world (The control)
• The worse kind of world
• Fighting sequence risk

What is Sequence of Return Risk

The performance of equities (stock market) is usually measured by the average annual return on your money. The keyword here is average, as equities rarely, if ever, deliver a fixed percentage return each year.

Because returns fluctuate, withdrawing money at any time or on a regular basis can significantly affect the final amount you accumulate. If withdrawals happen during a period of low or negative returns, you will have less capital left to compound.

This is what Sequence of Return Risk is all about, the combined impact of poor returns and withdrawals, especially when the poor returns occur consecutively.

Investopedia has a whole article [↗] on the subject if thats what you are interested in.

In this article, I will simulate some basic withdrawal scenarios and examine their impact on the final account balance.

YOu can

An ideal world (The control)

Its important to note that the only reason we are talking about sequencing risk is because of the the irregualar yearly returns, which constitue some down and some up years in returns.

To get started with our simulations, we need to setup a control, a reference point that we will look up to in other to try and achieve the same ending balance given the same withdrawals.

To do that we will assume we live in a perfect world were the equities market provides the same returns each year for a given number of years.

Here are the metrics we will use:

• We assume we have a starting invested capital of a $150,000
• We intend to withdrawal $6000 yearly which we adjust by a 3% inflation after the first year.
• We will also assume the equities market returns 10% each and every single year.

Given the above assumptions we will have a final balance of $207,764.22.

This number will serve as our north star, whatever withdrawl strategies we try out should attempt to get as close to this final balance as much as possible.

To run these numbers yourself you can use either:

• This Online calculator [↗]

• You can also run the Python code below:

✅ Wrap📋
01: annual_return_list = [10,10,10,10,10]
02: 
03: account_balance = 150_000
04: yearly_withdrawal = 6000
05: inflation_rate = 3
06: 
07: for year, annual_return in enumerate(annual_return_list, start=1):
08:     if year > 1:
09:         yearly_withdrawal +=  ((inflation_rate/100) * yearly_withdrawal)
10:     account_balance += (annual_return/100)*account_balance
11:     account_balance -= yearly_withdrawal
12: 
13: formatted_account_balance = format(round(account_balance,2), ',')
14: print(f"Final Account Balance: {formatted_account_balance}")  # Final Account Balance: $207,764.22

In the world of finance the are already established ways and suggestions on how to avoid sequencing risk

The worse kind of world

Instead of running a morte carlo simulation using different Now lets take the worse kind of return sequence and see how we can make the best out of it to come closer to the ideal world.

Strategy one

Reduced spending

Strategy two

pull all we can

Strategy three

Loaned spending

Fighting sequence risk

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