Why understanding the sequence of investment returns is so important

For investors, the order in which returns arrive can make the difference between success and failure. Imagine you are saving for 25 years (perhaps to help  your children to buy a home). Let’s say you earn 25% in your best year; you lose 25% in your worst year; every other year you earn 5%. Now consider the running order of your investment returns. If the running order of your returns is Worst > Average > Best you will be better off than in the opposite situation, where the running order is Best > Average > Worst. 

Does it really matter that much? 

In the example above, the difference between the favourable sequence (worst year comes first) and the unfavourable sequence (worst year comes last) is over 50%. That could mean your children get much less financial help…and do not move out. So yes, it matters. 

The last lap is the decider 

For long term savers with a fixed time horizon, the final years are critical. The accumulated pot is typically at its highest value after years of contributions and compounded investment return. Recall that in the early years of saving the investment return is less important to wealth building than the annual contribution; however, as time passes, this situation turns around and investment returns are the main driver of final wealth. So, it is important to maximise the return in these critical late years without jeopardising the pot.