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December 12, 2014 at 12:16 AM
There is always a great deal of conversation among advisors surrounding portfolio returns. Although the emphasis has been on the level of returns, there is another issue which has not garnered as much attention but is highly significant: the sequence of returns. Assuming a portfolio averages a specific annual return over some period of time, the order in which the returns occur can play a significant role in the portfolio’s ending value. This is especially true for clients who are making deposits and/or withdrawals. In short, when cash flows are present, the order of the returns is a major factor in the portfolio’s terminal value. To begin, let’s look at the assumptions I used in the analysis.
Assumptions
The analysis includes three different scenarios with three portfolios in each. Scenario One assumes there are no cash flows. Scenario Two assumes annual withdrawals of $50,000. Scenario Three assumes annual deposits of $20,000. We’ll also assume the portfolio averages 9.8% per year (geometric return), has a beginning value of $1 million and covers a 10-year period. Taxes, commissions and fees have been ignored.
In Portfolio A of each scenario, the returns will begin at 35% and decrease by 5% each year with a final return of negative 15%. Portfolio B in each scenario will reverse the order of the returns, beginning with negative 15% and increasing by 5% each year, ending with 35%. Portfolio C in each scenario will assume a 9.8% annual return which is the geometric return of portfolios A and B. This return will not vary. The zero percent return was omitted in the first two portfolios. The order of returns in each portfolio are displayed in the following table.
Scenario One: No Cash Flows
When cash flows are absent, the order of the returns is irrelevant. In this case, all portfolios reach the same terminal value of $2,541,167, although each takes a different route (see Graph A).
Scenario Two: Annual Withdrawals of $50,000
When withdrawals are present, the order of returns is important. In Scenario Two, Portfolio A begins with higher returns and ends with lower returns, making it the winner by a wide margin (see Graph B).
