Jerry Wagner, president of Flexible Plan Investments, has written some exceptionally informative articles in this space over the last five weeks.

I know that two in particular, “Don’t let your core go to waste” and “What if,” have received many favorable responses from readers. I urge you to check them out if you have not already.

Both of these articles talk about the wisdom of constructing a well-diversified portfolio that consists of several different dynamically risk-managed strategies. Jerry also explores the concept of “core” and “satellite” strategies.

The rationale given in “What if?” for this approach is powerful:

“The core should be dynamically risk-managed so that when markets change direction and are declining, you do not participate. Instead, during those times, you stand aside. The current vogue of investing in a static or periodically tweaked portfolio of index funds cannot do this. It continues to participate all right … even to the downside. …

“[Do] not place too few eggs in your portfolio basket. You need to invest in a large number of strategies to reflect the different types of market environments that are always possible.

“You may not know which market environment will occur next, but you do know that one different from the present one will occur. Only a diversified, dynamic, risk-managed portfolio can be better positioned and respond when those changes occur.”

The truly operative phrase here, I think, is “dynamic, risk-managed strategies.”

Why is that so important for investors?

For me, and many of the financial advisers I have interviewed for Proactive Advisor Magazine, it comes down to the concept of “the sequence of returns.”

Over the history of the U.S. stock market, given a long enough period of time, equity investors have been rewarded with growth in their portfolios. However, they have obviously faced periods of extreme volatility and steep drawdowns for those same portfolios.

When those losses occur for any given investor is really at the heart of the theory for the sequence of returns. Someone age 25, with 35-40 years of earning and saving years in front of them (the argument goes), can afford to “ride out” stock bear markets. This assumes they never sell out at or near the bottom, as so many people do.

However, for someone about to enter retirement and begin the distribution phase of their nest egg, as opposed to accumulation, a 30%–50% hit to their retirement funds early on will wreak havoc on their planned withdrawal rates. There is a good chance their funds will no longer last throughout a lengthy retirement.

I believe the concept of the sequence of returns started to gain some traction in the financial planning and investment community in the early 2000s. Consider individuals and couples who had experienced significant portfolio growth in the great equity bull market of the late 1980s and 1990s and were planning on retiring in the year 2000. They were immediately faced with three consecutive years of losses with a combined negative return of about 43% on the S&P 500. (The compounded “math” of bear market losses makes the impact even worse.)

To greatly simplify the idea, imagine these people planned to retire with an investment portfolio of $1,000,000 available to help fund their retirement withdrawals for the next 30 years. If they gained 40% in the first years of retirement, their $1.4 million would surely go a lot farther than the $600,000 they ended up with at the end of 2002, less withdrawals! While it is unlikely anyone was 100% invested in stocks, the concept still holds true.

Many investment firms and insurance companies have published their own versions of how the sequence of returns works. One of the largest mutual fund and ETF providers, BlackRock, illustrates it this way:

  • Three investors made the same initial hypothetical investment of $1,000,000 upon retirement at age 65.
  • All had an average annual return of 7% over 25 years, but each had a different sequence of returns.
  • All made annual withdrawals of $60,000, adjusted annually for inflation.
  • At age 90, all had different portfolio values due to annual withdrawals.

Looking at their hypothetical portfolio values, investor “A” had just over $1 million at age 90, investor “B” had $500,000, and investor “C” had zero.

This makes a powerful case for dynamic, risk-managed strategies that can mitigate the worst of bear market losses, especially for retirees or those on the cusp of retirement.

We explored this issue in some detail in Proactive Advisor Magazine. Please see “Can lower returns lead to more money in retirement?”

This article, written by a third-party investment-strategy consultant, finds that less-volatile, better risk-adjusted returns (as opposed to “average annual returns”) can result in “significantly more money in retirees’ pockets” over a lengthy time frame.

But what about those who are not close to or in retirement? I think the industry often ignores the sequence-of-returns issue for other investors. What about a couple in their 30s with young children who are planning on their first home purchase? How about a couple in their early 50s who are about to see children go off to college? If their savings/investments are exposed without risk management to the whims of the market, the same principles are in effect—the timing of investment returns can devastate their plans.

There are many reasons that dynamic, risk-managed strategies can benefit investors of all ages. I think the sequence of returns is one of the more important ones.

FPI Research update

The S&P 500 and NASDAQ Indexes have made new highs, with the Dow Jones Industrial Average not far behind. Uncertainty around tariffs, the Turkish economy, and geopolitical relations have resulted in short periods of volatility within the markets—but not enough to reverse course to the downside. From a technical standpoint, new highs accompanied by low volume represent the only potential roadblock we see to a sustained breakout that will trend to new value zones.

With the markets trending to new highs, let’s take a look at two of our main trend-following strategies that employ risk management when volatility rises—Classic and Self-adjusting Trend Following—to see what they are signaling.

Classic attempts to be “all-in” when market conditions are favorable and “all-out” when there are causes for concern. The strategy has held its long exposure for quite some time, signaling that conditions are still favorable to the long side.

Self-adjusting Trend Following is able to go 2X leveraged, single exposure, flat, and inverse. Currently, it is maintaining its 2X exposure in the NASDAQ 100. Leveraged exposure is typically maintained during technically favorable environments that are complemented by low volatility.

Both strategies are on the right side of current market movements and suggest that the breakout to new highs may be welcomed by investors. The benefit of both strategies is that if the breakout is a false move and markets begin to experience volatility and move to the downside, they both have the ability to reduce exposure and manage risk actively to protect against giving back profits.

PAST PERFORMANCE DOES NOT GUARANTEE FUTURE RESULTS.  Inherent in any investment is the potential for loss as well as profit.  A list of all recommendations made within the immediately preceding twelve months is available upon written request.  Please read Flexible Plan Investments’ Brochure Form ADV Part 2A carefully before investing. View full disclosures.