Why drawdowns matter

Drawdowns are public enemy #1 for retirement portfolios.

What are drawdowns? It’s the amount an account falls from it’s previous high point.

Example 1: Drawdowns are magnified when investment losses are coupled with portfolio withdrawals.

Example 2: Drawdowns can occur when there are investment gains that are less than portfolio withdrawals.

Drawdowns caused by investment losses without withdrawals slows the growth of your portfolio.

Drawdowns caused by investment losses and withdrawals could lead to reduced cash flow or running out of money.

When you experience large drawdowns matters.

Early Draw Downs

Sequence of returns risk is the risk of receiving bad investment returns early in retirement.

Bad investment returns could be:

• Large portfolio losses early in retirement (see example 2 above)
• Portfolio returns that don’t support withdrawals (see example 3 above)

Here is a simple example:

• The Red and Blue lines both:
  • Start with a $1,000,000 balance
  • Withdraw $45,000 in year one then increased by 2.5% each year after
  • Grow by 7.5% in year 3 through 28
• The Blue line starts with a 10% loss in years 1 and 2. In years 29 and 30, it grows by 10%.
• The Red line starts with a 10% gain in years 1 and 2. In years 29 and 30, it grows by 10%.

As you can see the results are dramatically different. Both portfolios averaged 6.50% returns. One portfolio ended with more than it started. The other went negative before year 29.

The example above use simple, hypothetical returns to set the framework. Unfortunately, sequence of returns risk isn’t just a cute academic exercise.

A historical example illustrating sequence of returns

Rita and Chase each have $1 Million. They don’t need to spend it since they plan on living on their pension and Social Security income.

Rita has never liked the ups and downs of the market. Even though she’s not planning on spending the money she still chooses to use a less volatile strategy.

Rita is smart and has researched different investment strategies. She understands the importance knowledge plays in committing to an investment strategy.

She decides that a strategy that combines stocks and bonds is best for her. She’s willing to sacrifice the growth of her portfolio since she knows the combination will reduce the downside.

Chase has built his wealth using his favorite stock fund and has an iron stomach to stick through down markets.

He chooses to invest his money just like he did throughout his career.

Chase’s bet pays off. His average return is 1.88% more than Rita’s.

Rita receives 12.07% while Chase receives 13.95%. This bet earned him over $4 million more than Rita.

Chase’s annual return was also higher than Rita’s return, 16 out of 25 years return. He won nearly two out of every three years. Congrats Chase!

The results here align with the basis of classical portfolio management. Accepting more risk is required to receive maximize long-term wealth.

What would happen if they took withdrawals?

Now let’s assume Rita and Chase need to withdraw from their portfolio. Rita will keep her portfolio that averaged 12.07%. Chase will keep his portfolio that averaged 13.95%.

Who is going to win?

When you take distributions from a portfolio, the math completely changes.

Rita and Chase still experience the same average return as before. However, Chase experiences larger drawdowns early in the sequence.

Because large drawdowns happened early in retirement, Chase’s account drops and never recovers enough to outpace Rita.

After taking distributions, Rita beat Chase by nearly $500,000!

Chase averaged 1.88% more than Rita over that time frame. He also had a better return than her 2 out of every 3 years. Wow! If you were given a crystal ball, would you be able to pass up the portfolio that would yield 1.88% more and outperform over 60% of the time?

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