STREET DOGS

From Ben Carlson at A Wealth of Common Sense:

In his book “The Ages of the Investor”, William Bernstein describes a mythical employer named Uncle Fred who offers investors a retirement savings scheme determined by the flip of a coin. One side of the coin results in a 30% annual gain, while the other side gives you a 10% loss in a given year.

Since the coin toss gives you a 50/50 shot at each outcome, this would give investors a compounded annual return stream of about 8.2% with a 20% standard deviation, not too far from the actual long-term results in the stock market.

Now let’s say you decide to contribute $1,000 each year for the next 40 years into Uncle Fred’s scheme. And let’s further assume the coin flip works out to give you 20 positive return years in a row followed by 20 negative return years in a row. In this scenario, you would end up with a little more than $100,000.

We can also look at the opposite side of this coin — 20 consecutive years of negative returns followed by 20 consecutive years of positive returns. This time your nest egg grows to more than $2.3m!

These scenarios include both awful and amazing luck, but it shows how the sequence of returns can lead to enormously different outcomes, even with the same annual returns from the market.

Sequence of return risk exists not only in the financial markets but also everyone’s personal finances. When you were born can have an outsized impact on where certain generations stand financially.

Sequence of return risk in the markets is completely out of your control. So is the year in which you were born, which is why luck often plays a larger role in people’s financial outcomes than most are willing to admit.