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Never Forget the 6-Foot Tall Man who Drowned Crossing the Stream that was 5-Feet Deep on Average

August 16, 2016 By Scotty

Don’t depend on “Average” Portfolio Investment Returns to fund your Retirement. The “Average Returns” just might not occur until your money is all spent! That’s because there is a Fundamental Difference between an Accumulation Portfolio and a Distribution Portfolio. In the Accumulation Portfolio, Time is your Friend. The Longer the Money remains in your Portfolio, the Longer the Investment Returns can Compound. The Money you Invested and the Earnings on that Money you Invested Multiply.

However, once Withdrawals begin from a Distribution Portfolio, any Money removed from a Declining Balance will result in a Permanent Loss. This Loss is caused by “Sequence of Returns Risk.” Let me explain.

Accumulation Portfolio Example

In an Accumulation Portfolio with no Withdrawals, the Sequence of Returns does not matter. If the $500,000 beginning balance is subject to a “Good” Return Sequence of 100% Gain in Year One, followed by a 50% Loss in Year Two the ending Portfolio Balance is $500,000.

$500,000 + $500,000 = $1,000,000 – $500,000 = $500,000.

If that same Accumulation Portfolio beginning balance of $500,000 is subject to a “Bad” Return Sequence of 50% Loss in Year One, followed by a 100% Gain in Year Two, the ending Portfolio Balance is the same $500,000.

$500,000 – $250,000 = $250,000 + $250,000 = $500,000.

Distribution Portfolio Example

In a Distribution Portfolio with Withdrawals, the Sequence of Returns matters a Great Deal! For Example, our Retiree needs to withdraw $250,000 from that same $500,000 Portfolio after Year One.

If the $500,000 Distribution Portfolio beginning balance is subject to a “Good” Return Sequence of 100% Gain in Year One, followed by a $250,000 Withdrawal, followed by a 50% Loss in Year Two, the ending Balance is $375,000.

$500,000 + $500,000 = $1,000,000 – $250,000 = $750,000 – $375,000.

However, if the $500,000 Distribution Portfolio beginning balance is subject to a “Bad” Return Sequence of 50% Loss in Year One, followed by a $250,000 Withdrawal, followed by a 100% Gain in Year Two, our Retiree will be broke.

$500,000 – $250,000 = $250,000 – $250,000 = $0 x $0 = $0.

The 100% Return is Irrelevant because there isn’t any money left to Compound!  The Point is, once Cash Outflows begin, it’s not enough for Returns to “Average Out” in the Long Run if the Portfolio could be Depleted before the “Good” Returns finally show up.

A 50/50 U.S. Stock/Bond Portfolio Blend returned about a 7% Average Annualized Return in the last Century. Therefore, some people are planning their Retirement expecting to Withdraw 7% from their Portfolio each year. That would be a mistake. The actual Sustainable Withdrawal Rate from a 50/50 Portfolio is actually closer to 4% adjusted annually for inflation.

Bridge builders don’t design their structures to withstand “Average” stresses. They build them to stand up against Extreme Events….Think about that the next time you cross a stream after a heavy rainfall…It might be a lot deeper than “Average.”

So, What do you think? Are you prepared for your Retirement? Have you thought about how much income you can Withdraw from your Retirement Portfolio? Please share your comments.

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