Sequence Risk

In the area of personal finance, an important concept that many investors ignore at their own peril is sequence risk. In essence, sequence risk describes the risk that you start withdrawing from your retirement savings at the worst possible time when the investment portfolio is suffering significant losses. In this case, the recovery in your retirement savings will be hampered by the fact that you are withdrawing assets from it, thus reducing the amount of money working for you to recover previous losses. But this sequence risk exists in any investment portfolio and not only when you start withdrawing assets from it.

To see how sequence risk works in a regular portfolio assume you have a very simple investment portfolio that invests 80% in the S&P 500 and 20% in the Nasdaq starting 30 years ago in 1994. I assume the S&P 500 is your core portfolio holding that you will always hold, no matter what, while you are flexible about your investment in the Nasdaq.

Now, put yourself back to the year 2000 (if you are old enough to have memories of equity markets from that time). After years of strong performance, the Nasdaq started to drop. You now have two choices. Hold on to your underperforming investment in the Nasdaq and tough it out, hoping that the index will recover. Or you can sell your Nasdaq investment and invest it in any random asset available to you that looks somewhat decent. For simplicity, I have provided you with the MSCI EAFE as an alternative.

Over the course of the full 30 years from 1994 to today, what would be the better strategy? Sticking with the Nasdaq and toughing it out or getting rid of the underperformer and switching to international stocks in the MSCI EAFE?

Note that at first glance sticking with the Nasdaq should be the better option. Over the last 30 years since 1994, the average annual return of the Nasdaq was 16% compared to a mere 6.6% per year for the MSCI EAFE. Even worse, the MSCI EAFE underperformed the S&P 500 which earned 10.8% per year over the last 30 years. Clearly, selling the Nasdaq after a bit of underperformance and switching to the loser markets abroad is a bad choice.

For simplicity and illustration purposes, I assume you sold the Nasdaq in October 2000 when it had dropped 20% from its peak and you switched to the MSCI EAFE and never changed back. Thus, from October 2000 onward, you hold a portfolio of 80% S&P 500 and 20% MSCI EAFE. And for the last 24 years, you have been sitting in these international stocks that earn 10% less than the Nasdaq each year. Obviously, you feel absolutely miserable about this choice and curse your decision.

But probably you aren’t.

Sticking with the S&P 500 and Nasdaq portfolio would have a return of 11.8% per year over the last 30 years. Switching from Nasdaq to MSCI EAFE in October 2000 and staying there would have generated an average annual return of 11.2%. But of course, a 0.6% return difference per year makes a huge difference. By sticking with the Nasdaq, you will have underperformed in the early 2000s as the tech bubble burst but then caught up pretty quickly as tech stocks recovered and avoided the fallout from the European banking crisis and the European debt crisis. Furthermore, you benefitted from the stunning performance of US tech stocks in the 2010s.

Ah well, you might want to reconsider that. Yes, today in late 2023 your portfolio of S&P 500 and Nasdaq would have created more wealth than a portfolio of S&P 500 and MSCI EAFE. But it would take until January 2018 to overtake the S&P 500 plus MSCI EAFE portfolio. For 17 years, you would have been better off switching from the underperforming Nasdaq in October 2000 to the low return MSCI EAFE.

The reason is that by switching from the Nasdaq to the MSCI EAFE you avoided sequence risk.

By selling the Nasdaq in October 2000 with a 20% loss from its peak value, you avoided the drawdowns of the years 2001 to 2003 when the Nasdaq kept underperforming even more. Instead, you were invested in an asset that performed poorly but better than the Nasdaq. And that little bit better performance in the early 2000s was enough to ensure you build up enough additional wealth that it took the Nasdaq until 2018 to close the gap!

Of course, you don’t have to stop selling the Nasdaq and switching to the MSCI EAFE. You can do the same every time your non-core holding drops 20% from its peak, constantly switching between the Nasdaq and the MSCI EAFE. If you follow that strategy, when would your portfolio of sticking with the Nasdaq have caught up with this simple switching strategy? Not to this day. To this day, this simple switching strategy is ahead of a portfolio that would have stuck with the Nasdaq and averaged annual returns of 12.0%.

And since you aren’t asking, the transaction costs would have been minimal with only six switches in the last 23 years.

Why does this simple switching strategy work? Because assets that have underperformed for a while keep underperforming in the future. Yes, eventually they recover their losses but by avoiding the drawdown with simple stop loss rules like “sell whenever the asset has dropped 20% from its peak” you avoid much of this sequence of poor returns. And even if you switch to a poor performing asset, this is still better than sticking with an underperforming asset.

All too often I see both retail and professional investors hang on to underperforming assets, particularly if these assets have been underperforming only by a little bit. They tell themselves that there is good value in these assets and that eventually, they will turn around. They may but by switching to any random asset while waiting for the recovery, you avoid digging a deeper hole in your portfolio and you can significantly improve your long-term performance.