Sequence of Return Risk

We have previously discussed the optimal level of risk based upon various personal criteria. As usual, there are major assumptions that need to be made about the performance of various asset classes. It is important that we keep in mind that these historical numbers are based on many years worth of data. Obviously, if one's time frame is shorter, you may want to take a second look at these longer-term performance numbers.

What matters most at this point in your life is not what has happened, but what will happen and whether you will come out ahead at the right time.

Your portfolio performance matters most during the period when you have the most invested. As professionals, we tend to make the mistake of quoting historical market returns based upon decades worth of data, whereas the average person plans his or her life in three, five, or ten-year segments at best. Some studies have shown that since 1925, large and small-cap stocks combined have lost money 31% of the time over one-year rolling periods; over five years they have lost money 13% of the time. Only over 20-year rolling periods did they not lose money. So what is the best way to utilize various asset classes within a shorter-time frame?

Remember the basic principle of investing – "buy low, sell high"? If you are in the growth stage of your wealth, then add to the asset class that has been underperforming. This is contrarian in nature, and opposite of what most of the investing public does when chasing returns, but will have a significant positive impact on long-term returns. This is why rebalancing is so important, especially if it is not done very frequently.

It can be more challenging for those of you who are already in retirement and in the distribution phase of your assets. Regardless, the same principle applies. If the bond portion of your portfolio is outperforming equities, when taking money out of your portfolio, you may want to take it from the bond assets and allow for the equity portion to recover.

It is always wise to have a cushion built up in cash and cash-related positions, so you are not forced into a situation of having to draw assets out when the market has corrected. This amount should generally range from three to six months worth of living expenses.

The bottom line is this: separate your decisions of what to invest in, or draw from, based upon the relative performance of the various asset classes in your portfolio. In the long-run, this will have a dramatic impact on the actual returns of your portfolio and will also keep your portfolio from becoming too unbalanced.

Feel free to contact me at ffiebig@zacks.com if you have any questions or comments.