{"id":109536,"date":"2025-02-25T17:33:01","date_gmt":"2025-02-25T17:33:01","guid":{"rendered":"https:\/\/peraltafinancing.com\/business\/investing\/alpacainvestments-part-2-sequence-of-returns-risk\/"},"modified":"2025-02-25T17:33:01","modified_gmt":"2025-02-25T17:33:01","slug":"alpacainvestments-part-2-sequence-of-returns-risk","status":"publish","type":"post","link":"https:\/\/fivemor.com\/?p=109536","title":{"rendered":"AlpacaInvestments: Part 2: Sequence of Returns Risk"},"content":{"rendered":"<p> <br \/>\n<\/p>\n<div id=\"post-body-5269964673256996539\" itemprop=\"description articleBody\">\n<div><span style=\"font-family: arial; font-size: medium; text-align: justify;\">\u00a0<\/p>\n<div class=\"separator\" style=\"clear: both; text-align: center;\"><a href=\"https:\/\/blogger.googleusercontent.com\/img\/b\/R29vZ2xl\/AVvXsEghXQHCESxMKoTdO2oLhnYz38yWTqD5lUDfITFesYKkrWKDmnRn7CisMEukgI8pD0GV6aSTacXwWfEwPBwetS3ffOod1GrjSf7Ub0r8tOIQYBoVJTvb3Yr7Cmq61G0mKV8I7aK76gWA3-6gAeMLIOoYYAFZdmGDWz-lWtixL9PbgbI5Lx0Vb67nMcPuyQ\/s940\/Sequence%20of%20Returns%20Risk.png\" imageanchor=\"1\" style=\"margin-left: 1em; margin-right: 1em;\"><img loading=\"lazy\" decoding=\"async\" border=\"0\" data-original-height=\"788\" data-original-width=\"940\" height=\"268\" src=\"https:\/\/blogger.googleusercontent.com\/img\/b\/R29vZ2xl\/AVvXsEghXQHCESxMKoTdO2oLhnYz38yWTqD5lUDfITFesYKkrWKDmnRn7CisMEukgI8pD0GV6aSTacXwWfEwPBwetS3ffOod1GrjSf7Ub0r8tOIQYBoVJTvb3Yr7Cmq61G0mKV8I7aK76gWA3-6gAeMLIOoYYAFZdmGDWz-lWtixL9PbgbI5Lx0Vb67nMcPuyQ\/w320-h268\/Sequence%20of%20Returns%20Risk.png\" width=\"320\"\/><\/a><\/div>\n<p><\/span><\/div>\n<p><iframe loading=\"lazy\" title=\"Using ChatGPT to help with projecting Financial Freedom numbers\" width=\"840\" height=\"473\" src=\"https:\/\/www.youtube.com\/embed\/aE0XYO6uNxg?feature=oembed\" frameborder=\"0\" allow=\"accelerometer; autoplay; clipboard-write; encrypted-media; gyroscope; picture-in-picture; web-share\" referrerpolicy=\"strict-origin-when-cross-origin\" allowfullscreen><\/iframe><\/p>\n<p class=\"MsoNormal\" style=\"text-align: justify;\"><span style=\"font-family: arial; font-size: medium;\">This is part 2 of the 4-part series on financial projections<br \/>\nfor achieving financial freedom. If you\u2019ve not read the first part, I\u2019ll<br \/>\nsuggest reading that post first and\/or watch my YouTube video above (give some<br \/>\nsupport to my first video!), which explains the overall framework for making<br \/>\nprojections that I\u2019m using to plan my financial freedom journey. <\/span><\/p>\n<p><span style=\"font-family: arial; font-size: medium;\">Part 2: Sequence of Returns Risk \u2013 A Crucial but Often Overlooked Factor<\/span><\/p>\n<p class=\"MsoNormal\" style=\"text-align: justify;\"><span style=\"font-family: arial; font-size: medium;\">The focus of this post is on one important section of the entire planning<br \/>\nprocess \u2013 that the <i>sequence of returns<\/i> is a huge factor that is often<br \/>\noverlooked when projecting your investment returns. If you\u2019re lucky, a<br \/>\nfavourable sequence of returns may fast forward your retirement target by a few<br \/>\nyears; if you\u2019re unlucky, it could wreck your retirement plans just as you<br \/>\nthink you\u2019re almost there.<\/span><\/p>\n<p class=\"MsoNormal\" style=\"text-align: justify;\"><span style=\"font-family: arial; font-size: medium;\">Try to recall the last time someone share about their<br \/>\ntargeted investment returns \u2013 your friend might say \u201cI am targeting a 10%<br \/>\nannual return\u201d. Or perhaps when you spoke to an insurance agent, who told you<br \/>\nthat the \u201cS&amp;P500 has an average return of 10%\u201d. But how exactly do we<br \/>\nproject this 10% into the future?<\/span><\/p>\n<p class=\"MsoNormal\" style=\"text-align: justify;\"><span style=\"font-family: arial; font-size: medium;\">A very common way of \u201cprojecting\u201d these future returns would<br \/>\nbe to simply extrapolate the expected annual returns and compound it over the<br \/>\nintended time horizon. <\/span><\/p>\n<p class=\"MsoNormal\" style=\"text-align: justify;\"><span style=\"font-family: arial; font-size: medium;\">For example, if someone intends to invest $10,000 per year,<br \/>\nand targets a 5% annual return over 10 years, extrapolating this 5% across 10<br \/>\nyears, compounded, will give you something like this:<\/span><\/p>\n<div class=\"separator\" style=\"clear: both; text-align: center;\"><a href=\"https:\/\/blogger.googleusercontent.com\/img\/b\/R29vZ2xl\/AVvXsEg3c7IgxbUAAYI2kax6SuiI618v_2QfCuJ2ig3Mya_O_8dwnKlsYN7YSvwmJW6NSwS3wIfesHpA5mKqZ-kvyYYt8RohaHOUvDO7HfO0hmMcvl3fMox3O1fkMVcgZ5w4jZtD57Pktq2eR5Q5HzlDosK1Qm4mVEzW4x2rZw1q7RgGKzxV1Lua6mCYmL6pWg\/s2432\/SOR1.png\" style=\"margin-left: 1em; margin-right: 1em;\"><img loading=\"lazy\" decoding=\"async\" border=\"0\" data-original-height=\"340\" data-original-width=\"2432\" height=\"89\" src=\"https:\/\/blogger.googleusercontent.com\/img\/b\/R29vZ2xl\/AVvXsEg3c7IgxbUAAYI2kax6SuiI618v_2QfCuJ2ig3Mya_O_8dwnKlsYN7YSvwmJW6NSwS3wIfesHpA5mKqZ-kvyYYt8RohaHOUvDO7HfO0hmMcvl3fMox3O1fkMVcgZ5w4jZtD57Pktq2eR5Q5HzlDosK1Qm4mVEzW4x2rZw1q7RgGKzxV1Lua6mCYmL6pWg\/w640-h89\/SOR1.png\" width=\"640\"\/><\/a><\/div>\n<p class=\"MsoNormal\" style=\"text-align: justify;\"><span style=\"font-family: arial; font-size: medium;\">At the end of year 10, this person would expect to have an<br \/>\nending capital of $132k, after investing $100k over 10 years at a 5% annual return.<\/span><\/p>\n<p class=\"MsoNormal\" style=\"text-align: justify;\"><span style=\"font-family: arial; font-size: medium;\">But does this resemble real world stock market returns?<br \/>\nClearly not\u2026<\/span><\/p>\n<p class=\"MsoNormal\" style=\"text-align: justify;\"><span style=\"font-family: arial; font-size: medium;\">This \u201c5% compounded annual return\u201d is merely the long-term <i>compounded<br \/>\nannual growth rate<\/i> \u2013 the \u201cCAGR\u201d. From year to year, returns may differ <b>very<br \/>\nsignificantly<\/b>: In 2021 the S&amp;P500 gained 27%, while in 2022 it fell by<br \/>\n19%.<\/span><\/p>\n<p class=\"MsoNormal\" style=\"text-align: justify;\"><span style=\"font-family: arial; font-size: medium;\">To illustrate how the <b><i>sequence of returns<\/i><\/b><br \/>\nimpact the returns of someone who is <b><i>investing consistently over time<\/i><\/b>,<br \/>\nconsider the following two examples:<\/span><\/p>\n<div class=\"separator\" style=\"clear: both; text-align: center;\"><a href=\"https:\/\/blogger.googleusercontent.com\/img\/b\/R29vZ2xl\/AVvXsEiet3cnJkXAayPsqjfshMssO7OlJqZNND_9Bkr2r1JJzwHgb--NCkT0sxJpYWLOnQm5HL6Bb4C69cLXQXWLLVwl2eZJBNaC6UrKX-XGI5Bz0myq34kWOqYnJTFznF-wWLpNfeTOyAB1AGX04E1gu2yMML_tO1mVEKcCe6RrkRJqb2CvL5CPoaTwzGP-Uw\/s2433\/SOR2.png\" style=\"margin-left: 1em; margin-right: 1em;\"><img loading=\"lazy\" decoding=\"async\" border=\"0\" data-original-height=\"481\" data-original-width=\"2433\" height=\"126\" src=\"https:\/\/blogger.googleusercontent.com\/img\/b\/R29vZ2xl\/AVvXsEiet3cnJkXAayPsqjfshMssO7OlJqZNND_9Bkr2r1JJzwHgb--NCkT0sxJpYWLOnQm5HL6Bb4C69cLXQXWLLVwl2eZJBNaC6UrKX-XGI5Bz0myq34kWOqYnJTFznF-wWLpNfeTOyAB1AGX04E1gu2yMML_tO1mVEKcCe6RrkRJqb2CvL5CPoaTwzGP-Uw\/w640-h126\/SOR2.png\" width=\"640\"\/><\/a><\/div>\n<p class=\"MsoNormal\" style=\"text-align: justify;\"><span style=\"font-family: arial; font-size: medium;\">What the above two scenarios show is that during the<br \/>\naccumulation phase \u2013 the phase where you are earning an active income, saving<br \/>\nup and investing for your retirement, apart from the obvious factors like increasing your income, reducing expenses and having a higher allocation to equities given your longer time horizon&#8230; T<\/span><span style=\"font-family: arial; font-size: medium; text-indent: -18pt;\">he <\/span><i style=\"font-family: arial; font-size: medium; text-indent: -18pt;\">sequence of returns<\/i><span style=\"font-family: arial; font-size: medium; text-indent: -18pt;\"> actually play a huge part in<br \/>\ndetermining whether you can hit your retirement goals sooner or later.<\/span><\/p>\n<p class=\"MsoNormal\" style=\"text-align: justify;\"><span style=\"font-family: arial; font-size: medium;\">From the two scenarios above, even though in both cases the <b>CAGR<br \/>\nover 10 years is the same 5%<\/b>, and both people are investing the same<br \/>\n$10,000 per year, simply because the \u201clucky\u201d person A experiences the \u201cbad\u201d<br \/>\nreturns in the earlier years (when less capital is at stake), while the<br \/>\n\u201cunlucky\u201d person B faces the \u201cbad\u201d returns in the later years (when more<br \/>\ncapital is at stake), they end with a <b>huge<\/b> difference in ending capital $194k vs $94k, a whopping $100k difference!<\/span><\/p>\n<p class=\"MsoNormal\" style=\"text-align: justify;\"><b><span style=\"font-family: arial; font-size: medium;\">How do I account for sequence of returns risk?<\/span><\/b><\/p>\n<p class=\"MsoNormal\" style=\"text-align: justify;\"><span style=\"font-family: arial; font-size: medium;\">Having said the above, how do I then account for the<br \/>\nsequence of returns risk, when coming up with projections for accumulating my<br \/>\nfinancial freedom portfolio?<\/span><\/p>\n<p class=\"MsoNormal\" style=\"text-align: justify;\"><span style=\"font-family: arial; font-size: medium;\">I decided the best way would be to run a range of<br \/>\nsimulations, where the returns are <b>randomised <\/b>in each year \u2013 within a given long-term<br \/>\naverage and standard deviation. Stock market returns generally follow a normal distribution, although in the real world there are <b>fat-tail risks <\/b>that would not be captured here.<\/span><\/p>\n<p class=\"MsoNormal\" style=\"text-align: justify;\"><span style=\"font-family: arial; font-size: medium;\">For my projections, I decided to use a 5% long-term average<br \/>\nreturn, and a 15% standard deviation. These are in line with the long-term<br \/>\nhistorical averages for the MSCI ACWI.<\/span><\/p>\n<p class=\"MsoNormal\" style=\"text-align: justify;\"><span style=\"font-family: arial; font-size: medium;\">Let\u2019s look at the same example above, but in this case<br \/>\napplying the randomised returns based on a 5% average and 15% standard deviation.<br \/>\nFor simplicity, we will cap the maximum annual increase and decrease at +\/-<br \/>\n30%, so that we don\u2019t end up with too extreme numbers.<\/span><\/p>\n<p class=\"MsoNormal\" style=\"text-align: justify;\"><span style=\"font-family: arial; font-size: medium;\">By running 30 iterations of the above parameters, we get<br \/>\nthis chart which shows the 30 scenarios.<\/span><\/p>\n<div class=\"separator\" style=\"clear: both; text-align: center;\"><a href=\"https:\/\/blogger.googleusercontent.com\/img\/b\/R29vZ2xl\/AVvXsEhesXe7T0Q4cuOczVSP1f-kP_pfC2h8Vox_iJM5bKXNgiRYXSJVE1Po1hmZiqVS3ekRVcio86cQPHSDGAUIYfXa-B_9uWLKMlgSH8cJQ3AxNDyo9qb9D4q-ezhL-n73dGW4FCYxDIXWd0sbBPBJwKVXeCdS_UnBl3raHHfEBjxfsVv2fYM5ba7UL9xpwg\/s694\/SOR3.png\" style=\"margin-left: 1em; margin-right: 1em;\"><img loading=\"lazy\" decoding=\"async\" border=\"0\" data-original-height=\"482\" data-original-width=\"694\" height=\"278\" src=\"https:\/\/blogger.googleusercontent.com\/img\/b\/R29vZ2xl\/AVvXsEhesXe7T0Q4cuOczVSP1f-kP_pfC2h8Vox_iJM5bKXNgiRYXSJVE1Po1hmZiqVS3ekRVcio86cQPHSDGAUIYfXa-B_9uWLKMlgSH8cJQ3AxNDyo9qb9D4q-ezhL-n73dGW4FCYxDIXWd0sbBPBJwKVXeCdS_UnBl3raHHfEBjxfsVv2fYM5ba7UL9xpwg\/w400-h278\/SOR3.png\" width=\"400\"\/><\/a><\/div>\n<p><\/p>\n<p class=\"MsoNormal\" style=\"text-align: justify;\"><span style=\"font-family: arial; font-size: medium;\">I overlaid the \u201clucky\u201d (person A, in green) and \u201cunlucky\u201d (person B, in red)<br \/>\nscenarios on the chart, to show how these stand, relative to the other<br \/>\nsimulated returns. I also included the base case \u201cstraight-line 5% return\u201d<br \/>\nscenario (in orange), to illustrate how a range of 30 potential real-world returns may<br \/>\ndiffer significantly from this base case. <\/span><\/p>\n<p class=\"MsoNormal\" style=\"text-align: justify;\"><span style=\"font-family: arial; font-size: medium;\">Note that because the returns are randomised with an average<br \/>\nof 5% and a standard deviation of 15%, the CAGR for the 30 simulations may end<br \/>\nup greater or less than 5%.<\/span><\/p>\n<p class=\"MsoNormal\" style=\"text-align: justify;\"><b><span style=\"font-family: arial; font-size: medium;\">Key takeaway when projecting Financial Freedom numbers<\/span><\/b><\/p>\n<p class=\"MsoNormal\" style=\"text-align: justify;\"><span style=\"font-family: arial; font-size: medium;\">Now that we know the <i>sequence of returns<\/i> play a key<br \/>\nrole in determining the outcome of our capital accumulation phase, how do we<br \/>\nuse this to project when would we be able to retire early, which is what many<br \/>\nof us are aiming for? <\/span><\/p>\n<p class=\"MsoNormal\" style=\"text-align: justify;\"><span style=\"font-family: arial; font-size: medium;\">You need to know your required annual cash flows during<br \/>\nretirement, based on today\u2019s purchasing power. Then, adjust this cash flow figure<br \/>\nover time to account for inflation.<\/span><\/p>\n<p class=\"MsoNormal\" style=\"text-align: justify;\"><span style=\"font-family: arial; font-size: medium;\">You need to decide on your safe withdrawal rate. The number<br \/>\noften being brought up is 4%, although you may use a lower figure if you\u2019re<br \/>\nmore conservative. <b>Alternatively<\/b>, for dividend investors (like me), the<br \/>\nquestion to ask is \u2013 what is the expected dividend yield I can get from my<br \/>\nportfolio?<\/span><\/p>\n<p class=\"MsoNormal\" style=\"text-align: justify;\"><span style=\"font-family: arial; font-size: medium;\">Lastly, depending on how much you expect to invest each<br \/>\nyear, you will be able to generate a <i>probability distribution<\/i> of when<br \/>\nyou will <i>likely <\/i>be able to reach these targets, which is either the<br \/>\npoint when:<\/span><\/p>\n<ul>\n<li><span style=\"font-family: arial; font-size: medium; text-indent: -18pt;\">Based on your safe withdrawal rate, your<br \/>\nportfolio size can cover your inflation adjusted retirement expenses, or,<\/span><\/li>\n<li><span style=\"font-family: arial; font-size: medium; text-indent: -18pt;\">Based on your expected dividend yield, your<br \/>\nportfolio can generate enough cash flows to sustain your inflation adjusted<br \/>\nretirement expenses.<\/span><\/li>\n<\/ul>\n<p class=\"MsoNormal\" style=\"text-align: justify;\"><span style=\"font-family: arial; font-size: medium;\">To conclude, I think there\u2019s value in viewing things based on<br \/>\n<i>probabilities<\/i>. By acknowledging the <i>likelihood<\/i> of different<br \/>\noutcomes, we can make more informed decisions and prepare for a range of outcomes.<br \/>\n<\/span><\/p>\n<p class=\"MsoNormal\" style=\"text-align: justify;\"><span style=\"font-family: arial; font-size: medium;\">I tend to view things in life in terms of probabilities.<br \/>\nWhen it comes to my investments, I take the same approach.<\/span><\/p>\n<p class=\"MsoNormal\" style=\"text-align: justify;\"><span style=\"font-family: arial; font-size: medium;\">May the odds be ever in your favour.<\/span><\/p>\n<\/div>\n\n","protected":false},"excerpt":{"rendered":"<p>\u00a0 This is part 2 of the 4-part series on financial projections for achieving financial freedom. If you\u2019ve not read the first part, I\u2019ll suggest reading that post first and\/or watch my YouTube video above (give some support to my first video!), which explains the overall framework for making projections that I\u2019m using to plan [&hellip;]<\/p>\n","protected":false},"author":1,"featured_media":109539,"comment_status":"open","ping_status":"open","sticky":false,"template":"","format":"standard","meta":{"footnotes":""},"categories":[96],"tags":[27438,3341,10970,11115,18026],"dealstore":[],"offerexpiration":[],"class_list":["post-109536","post","type-post","status-publish","format-standard","has-post-thumbnail","hentry","category-investing","tag-alpacainvestments","tag-part","tag-returns","tag-risk","tag-sequence"],"yoast_head":"<!-- This site is optimized with the Yoast SEO plugin v26.4 - https:\/\/yoast.com\/wordpress\/plugins\/seo\/ -->\n<title>AlpacaInvestments: Part 2: Sequence of Returns Risk - Som2ny Network<\/title>\n<meta name=\"robots\" content=\"index, follow, max-snippet:-1, max-image-preview:large, max-video-preview:-1\" \/>\n<link rel=\"canonical\" href=\"https:\/\/fivemor.com\/?p=109536\" \/>\n<meta property=\"og:locale\" content=\"en_US\" \/>\n<meta property=\"og:type\" content=\"article\" \/>\n<meta property=\"og:title\" content=\"AlpacaInvestments: Part 2: Sequence of Returns Risk - Som2ny Network\" \/>\n<meta property=\"og:description\" content=\"\u00a0 This is part 2 of the 4-part series on financial projections for achieving financial freedom. 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