What is Sequence of Return Risk?
Bear markets offer great opportunities for young people
What is the Sequence of Return Risk? Although I have mentioned the explanation about this risk in my book ‘5-Minute Investment in One Year’, I found that many investors still did not grasp the opportunity brought by this risk. Especially in the first half of 2022, the market trend was different from the bull market in 2021. The global stock market ETF VT has fallen by 20.53% as of 07/01/2022, which belongs to the definition of bear market in the academic community.
Many investors were thrilled to enter the market during the past few years of growth, hoping to see their assets appreciate. However, they were caught off guard when the market suddenly took a downturn. As a result, many people are now worried that the market will continue to fall, and have decided to stop buying assets or even sell their existing ones and leave the market, planning to come back when the market “bottoms out.”
What you may not realize is that this is not the right course of action at all. In fact, it may actually increase your risk. Instead, it’s time to reexamine and understand the benefits of staying in the market and enjoying the rewards of sequence risk.
The key is to keep buying and hold on for the long-term.
What is Sequence of Return Risk?
Sequence of Return Risk is the risk associated with the order in which investment returns are received. This risk can lead to different investment outcomes for investors facing the same volatility. If this concept seems confusing, let me explain it using a simple example with the global index ETF:VT.
But before we dive into that, let’s first understand how stock prices are calculated using a series of returns.
If we have a sequence of numbers like 1, 2, 3, 4, 5 and multiply them together, we get 120.
Now, let’s assume that this sequence represents the daily price changes of a stock.
If the stock starts at a price of $1 and we multiply the daily price changes in this sequence, we’ll end up with a final price of $120.
However, if we change the order of the sequence to 1, 3, 2, 4, 5 or 5, 4, 3, 2, 1, we’ll still get the same final price of $120 because multiplication is associative and commutative.
Now, let’s add an important assumption: future stock prices will be higher than they are now. This assumption is made by index investors who believe in the long-term growth of the economy and the stock market.
Therefore, we can assume that stock prices will eventually reach new highs in the future.
So, the question now is, if the future stock price is $120, how does the order of the returns affect the accumulation of an investor’s assets?
The Sequence of Return Risk with VT
According to Vanguard’s website, VT has had the following annual returns from 2008 to 2021:
- Out of the past 14 years, only 4 years had negative returns, and over 70% of years had positive returns.
- Even in the year of COVID-19, 2020, it still had a return of 16.74%.
- The average annual return is 9.46%, and the annualized return rate is 13.35%.
If we assume that the issuing price of VT was $100, based on the historical ups and downs, the stock price would have fluctuated like this each year:
Next, let’s simulate a small investor who invests $10,000 each year from 2008 to the end of 2021, with a total investment of $140,000. By the beginning of 2022, their assets will accumulate to $345,509.
- The annualized return rate is 11.41%.
So far, we have simulated an investor who invests $10,000 each year in the VT ETF until the end of 2021. With simple interest, they would earn $200,000 in total, and the annualized return rate with compound interest would be 11.41%.
Remember all of this information.
Now, let’s do something different and reverse the order of VT’s past 14-year returns.
The result of reversing the sequence of its ups and downs is shown below:
If we compare this with the previous chart of corresponding stock prices, we see that changing the order of annual returns results in the same starting and ending points for the stock price, but the numbers in the middle are different. This is the essence of return sequence risk.
Let’s simulate the same behavior by an investor who invests $10,000 each year in the reversed sequence of VT, and see what happens.
- Their accumulated assets would be $220,000, with simple interest earnings of $80,000.
- The annualized return rate is 5.84%.
Wait a minute, how can simply changing the order of returns result in such a significant difference in final assets?
- With the normal return sequence, the final assets were $345,000, but with the reversed sequence, they were only $220,000.
- That’s a difference of 54% in assets!
The key factor causing this difference is the number of units of assets.
The key concept behind the term “Sequence of Return Risk” is that bear markets can actually be a gift
When we want to understand the current value of our assets, we multiply the number of units of the asset we own (i.e. the number of shares) by the current price of the asset.
For example, if you own 10 shares of VT and the current price of VT is 100 dollars, your asset value would be 10 x 100 = 1000 dollars.
The number of shares (i.e. units of the asset) we own and the settlement price are two key factors that determine the value of our assets.
As previously mentioned, it is assumed that the settlement price will be higher than the current price.
Furthermore, as index investors believe that global economic growth will continue, their outlook for the future of global stock prices is that the market will eventually reach new highs. Therefore, we can assume that stock prices in the long run will be higher than they are now.
Therefore, the remaining factor that determines the future value of your assets is the “number of asset units”.
Going back to the example of VT, as shown in the chart of asset changes below, it is very clear that the order of price changes can cause different final values.
The key factor that causes the difference in asset value is the “number of units” purchased each year.
If we further analyze, the reason for the difference in asset value lies in the number of “units” that can be purchased each year under different return sequences.
The following chart shows the number of units that can be purchased each year under different return sequences.
- The blue units per year are always more than the orange ones.
- Total units in original return sequence: 1193
- Total units in reversed return sequence: 760
When we calculate the final asset value, we simply multiply the number of shares we hold by the final price. In this example, the final price is the same for both cases, so the only difference is the number of shares held.
Therefore, the key factor that determines the final asset value is the number of shares held, which is also known as the unit of asset.
If asset unit is so important, the more shares you have, the better.
So how can an investor who executes dollar-cost averaging (investing the same principal amount each year) increase their asset unit?
According to the calculation formula: the number of units purchased each year = principal / VT price for that year.
Assuming the principal investment amount remains the same, the investor can only acquire more shares when the VT price drops.
Do you now realize something important?
A bear market decline is the best opportunity to accumulate shares.
Looking at market trends from the perspective of accumulating assets, the more the market drops, the better.
For example, with the same investment principal of $100, if the VT price is $100 per share, you can only buy 1 share. But if the VT price drops by 99% to just $1, you can acquire 100 shares. We all believe that VT will eventually return to its original price point and even surpass it.
By then, the focus will not be on the VT price, but rather on how many shares of VT you hold.
Therefore, as long as you have any money to invest, a market decline is the best gift that the market can give you, especially during a bear market decline, which is like a big discount sale.
Don’t miss out on the best opportunity to accumulate shares.
Summary
In the long process of accumulating assets, investors will see changes in asset prices, sometimes rising and sometimes falling. Therefore, using price as a measure of investment quality is completely wrong. At this stage, you don’t need to settle the assets.
In the accumulation stage, what you should focus on is the number of asset units you have.
Therefore, in this article, I hope to bring you the following thoughts about Sequence of Return Risk:
- In the accumulation stage, you must seize the opportunity to buy during a downturn.
- The number of asset units you own is the key.
- You cannot control the order of returns, but you can anticipate that future stock prices will be higher.
- The earlier you buy during a downturn, the faster you accumulate.
I hope you remember:
As long as there is future money to invest, both current and future price ups are unfavorable.
I know very well not to expect market gains in the future, but instead hope for a downturn, which is very counterintuitive.
However, if we think from a different perspective, what I really want you to understand is that during any downturn in the accumulation stage, you should be happy and brave to buy in.
Because only then can you purchase discounted assets and greatly increase the number of shares you hold.
Do not stop buying, and do not ask how much assets you have.
However, I understand that investors in the process of accumulating assets are unlikely to ignore the prices of assets, but focusing on prices is harmful to you.
Once investors are affected by market price fluctuations, they will be affected emotionally. Overemphasizing these prices is actually not conducive to asset accumulation.
Because what most people think of as a downturn is what causes them to deviate from their goals, but what I want to emphasize is that only buying in during a downturn in the process can accelerate your progress towards financial goals.
It’s not easy to buy during market downturns, but in the past few articles, I have assisted you from different angles to persevere until the end:
- The mindset of buying during downturns
- Methods to change the annualized return rate
- The compounding 82 rule (over 80% of wealth accumulation comes from investing in the first 20 years)
I hope to fully help you understand that once investors change their pessimistic thinking to optimistic, and continue to buy according to their plan instead of trying to sell and leave the market, there is a high probability of better asset accumulation in the future withdrawal stage.
There’s no reason, just because the bear market’s downturn is the best time to accumulate stocks.
Please take advantage of this opportunity and don’t give up easily!
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