The volatility of the stock market plays a major role in your account balance over time—for better and for worse. But even though stock market risk is an inherent part of investing, there’s another angle you might not be considering: the timing, or sequence, of your portfolio’s performance.
Why “Sequence Risk” Matters
A major market correction of 20%, for example, will have more of an effect on investors who need that money for retirement right now and don’t have time to recover from a loss. A 20% decline might not matter as much for investors who have decades to go before they start spending.
Investors in and around retirement often have large sums of money saved up. Those at the beginning of their careers might have small amounts, but they have more time to keep adding to their portfolios and for those investments to compound (i.e., earn money on the investments and on any earnings after that.)
Sequence Risk in Action: Two Investors, Two Different Outcomes
Can two people who invest the same monthly amount and get the same returns end up with different portfolio values? Almost certainly.
Same Returns
Same contributions: $400 per month
Same holding period: 10 years
Same average returns: 176% (cumulative) or 10.7% (average)
Different Outcomes
Investor A has $64,386
Investor B has $100,762
Why?
Everything was equal except for when they experienced gains and losses.
Here’s how we came up with those numbers. Investor A and Investor B both invested $400 a month—but during two different 10-year periods. Investor A’s 10-year investment is represented by actual S&P 500 Index® returns from 9/1/1994 to 8/31/2004. Investor B's investment is represented by S&P 500 returns from 8/1/2008 to 7/31/2018.
Each 10-year period had the same cumulative return (176%) and average annualized return (10.7%). But notice how the path to those returns was very different.
Early or Late? Timing of Market Gains and Losses
Investor A was the clear winner early on. Investor B had a rocky start, but it didn’t result in major dollar losses because of the small account balance at the time. Eventually, Investor B experienced slow, steady, compounding returns.
But when Investor A ran into a few tough years, there wasn’t enough time to recover. The negative returns later in the period had much more of an effect on their larger account balance. The result? Investor A ended up with $36,376 less.
Late Losses Drag Down Investor A’s Final Balance
Source: Morningstar Direct. The stock market is represented by the S&P 500® Index between 9/1/1994 to 8/31/2004 (Investor A, blue) and between 8/1/2008 to 7/31/2018 (Investor B, green). Data assumes reinvestment of dividends and capital gains. The index does not reflect fees, brokerage commissions, taxes or other expenses of investment. Investors cannot invest directly in an index. Past performance is no guarantee of future results.
The Timing of Big Stock Declines Could Spell Big Trouble
What does this mean for you? The bad luck of bad stock performance right before or soon after retirement—when your account balance is likely at its peak—could have a significant impact on your standard of living.
You never know what your sequence of stock returns will be, but there are strategies that can lower your overall risk. Gradually lowering your stock exposure is one way to help you avoid larger losses as you approach retirement.
Stocks or Bonds? You Need Both
Stocks and bonds have different purposes in your portfolio. While stocks might get a bad rap because several types of events can cause them to be volatile, most people still need the growth potential of stocks before and even during retirement. The trick is to balance your need for growth by complementing your stocks with other investments—like bonds—that tend to behave differently in various market conditions and can potentially lower your risk of large losses.
How much of each do you need in your portfolio? That depends on your comfort with risk and your time frame. But our research indicates that a gradual approach to reducing stocks and adding bonds might better manage sequence risk and temper the risk of market volatility.
Balance Your Stocks and Bonds Over Time (Hypothetical Risk Transition)
Source: American Century Investments.
Does Your Portfolio Need To Shift?
If you’re headed toward retirement with a portfolio full of stocks, it might be time to reevaluate. A diversified mix of stocks, bonds and short-term investments (like short-duration bonds or money markets) is ideal—as long as it matches your goals.
Learn more about solutions that can help.
Rebalancing allows you to keep your asset allocation in line with your goals. It does not guarantee investment returns and does not eliminate risk.
Diversification does not assure a profit nor does it protect against loss of principal.
Investment return and principal value of security investments will fluctuate. The value at the time of redemption may be more or less than the original cost. Past performance is no guarantee of future results.
Generally, as interest rates rise, the value of the bonds held in the fund will decline. The opposite is true when interest rates decline.
This material has been prepared for educational purposes only. It is not intended to provide, and should not be relied upon for, investment, accounting, legal or tax advice.
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