SEQUENCE-OF-RETURN RISK CAN DERAIL a retiree’s finances, as we discussed in the chapter on retirement. But what’s bad news for retirees can be good news for retirement savers.
Imagine your goal is to amass the maximum sum for retirement. What sequence of returns would you want? Sure, it’s gratifying when a market rally bloats your portfolio’s value. But what you really want are lousy returns throughout your working years, followed by a world-class rally right before you retire. That way, you would buy investments at rock-bottom prices and cash out at nosebleed valuations.
Unfortunately, stock market declines often cause folks to freeze and stop adding fresh money to their retirement stash. But if you want to make serious money, this is the time when you should continue to sock away money regularly and even step up your savings rate.
The importance of the sequence of returns, and how you react to good and rotten markets, is captured by the difference between time-weighted and dollar-weighted returns. Examples of time-weighted returns include the results you see published by mutual funds and exchange-traded index funds. They would accurately reflect your performance if you had invested, say, five years ago and never subsequently added or withdrew money.
But such time-weighted returns may be misleading if, for instance, the market had dropped sharply during the five years and then rebounded, and you continued to save regularly throughout this period, possibly using a strategy known as dollar-cost averaging. In that case, your personal performance would be higher than the time-weighted return, because some of your purchases would have occurred at the lower prices. To gauge your performance accurately, you would want to calculate a dollar-weighted return, which reflects when you bought and sold. Fortunately, some mutual fund companies do the calculation for their investors. This performance number is often labeled your “personal rate of return.”
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