A Cautionary Tale: The S&P and the Perilous Sequence of Returns by Steve Abramowitz

The Beatles got it right. If your life has been anything like mine, it’s been a “long, winding road.” It’s undoubtedly been an interesting journey, fraught with more health and relationship hardship than you had planned for. Chastened by the vicissitudes of life, you’re ready to head home and write the last chapter.

Retirement beckons and you’re smug. After all, you saved diligently, invested wisely and amassed a nest egg far in excess of what you had ever dreamed possible. Right now, you’re in that dependable midnight blue Toyota you bought when it was two years old to sidestep the precipitous depreciation of a new car. But you are tired and your eyes are closing intermittently after the tortuous trip.

Soon you can just make out an orange “MEN WORKING” sign flashing red. You open the window for the approaching flagman who recommends you follow the arrow pointing to the detour because it’s safer. Still, you ponder for a while. The ride has been faster in the left lane and you’re anxious to get home. Which way to go?

If you’re speeding toward the promised land of retirement or barely starting out, you need to heed a very different kind of warning: CAUTION: WATCH FOR APPROACHING SEQUENCE OF RETURNS.

What is this perilous sequence of returns you’ve been hearing about? It refers to the possibility that the market falls into a steep decline just before or soon after you enter retirement. What’s the problem, you say? The market has seesawed up and down for all the years you’ve been in it. What’s the big deal? The big deal is this. Whether you get a favorable or unfavorable sequence of returns is largely a matter of chance. You need to know when to hold your broad market index fund and know when to fold it.

How Dangerous Is the Sequence of Returns?

An unlucky sequence of returns could have three dire consequences. First, consider the magnitude of the loss in your retirement kitty. When early in the game you had only $50,000 socked away, a bear market might have set you back $15,000. But by now the compounding of your methodical monthly contributions and 10% average annual profit has rewarded you with a retirement stash of over a million. Chopping 30% off the top at this late juncture would cost you a cool $300 thou.

This nightmare itself has two major unwelcome consequences, one obvious and the other subtle. Depending on your withdrawal formula, you may soon find it difficult to cover everyday living expenses without a supplementary cash infusion or Draconian budget cut. Less self-evident is how the reduced balance would restrict your ability to participate in the inevitable market recovery and, in turn, to assure you do not outlive your available funds.

But you’re okay, right, because you’re in a broad market index fund. No, you’re not totally safe, especially if your core stock position is the Vanguard S&P 500 index ETF (VOO; mutual fund VFIAX) or Total Stock Market index ETF (VTI; mutual fund VTSAX). Why? Because one-third of your precious retirement investment is in volatile technology stocks, and disproportionately in gargantuan companies whose prices have been juiced by the artificial intelligence mania.

Just how big is a third in a single sector? Well, a plus-30% tech exposure is almost as high as it was in 2000 right before the dot.com crash. Remember when energy was 15% of the S&P during the Middle East turmoil of the seventies? Now it’s less than 4%. Of course, given the promise of AI and the likely continued dominance of technology in our society, it’s highly improbable that tech stocks are headed for that stark a demise.

What’s the Detour Like, Anyway?

If you decide to pick a new card, hope for Vanguard’s Dividend Appreciation ETF (VIG; mutual fund VDADX). It’s not as big or well-known as Vanguard’s two primary broad market index funds, but it’s no slouch with almost ninety billion in assets. It’s a domestic, large blend fund yielding 1.7%, costing a very reasonable .06 and holding about 350 stocks.

Although that’s fewer than VOO’s 500 or VTI’s several thousand, the fund is actually more diversified. Instead of almost a one-third weight in technology, you get a more reasonable 24%. No other sector’s weight exceeds 20% and individual stocks are capped at 4%. The six most heavily weighted companies in the S&P are tech stocks, whereas only two are in VIG’s top ten. In addition, 30% of VIG’s holdings are in utilities, consumer staples and health, the three most defensive S&P sectors, as against the Vanguard 500’s 21%.

Folks, let’s put it this way. Vanguard Dividend Appreciation looks a lot more like the historical S&P than the current tech-bloated S&P does. Plus, the fund invests only in companies that have raised their dividends for over ten years, and so excludes some of the possibly overvalued high-flyers like Nvidia and Tesla.

But what kind of dividend fund is one that yields less than 2%, hardly more than either VOO or VTI? Dividend Appreciation is a dividend growth fund, not a high yield fund. It selects high quality stocks that have desirable free cash flow and a management willing and able to increase the dividend year after year. Its current dividend growth rate is a whopping 8%.

Can You Still Accelerate?

The dividend fund may be more balanced, but can it perform as well as the S&P? Definitely. Over the last three years VIG returned an average annual 9%, the same as for the S&P and a percent more than the total market fund. Through the first eight months of this year, the direction of the differences was slightly reversed, presumably because of VIG’s less concentrated megacap tech positions. Dividend Appreciation advanced 16% as compared with the S&P’s 20% and VTI’s 18%.

Is it Safe to Drive?

Okay, so Vanguard Dividend Appreciation has an acceptable performance profile, but is it really safer than the two tried-and-true index stalwarts? Again, in the affirmative. The dividend growth fund gyrates only about 85% as much as the S&P. Not surprisingly, given its more defensive and less tech-heavy portfolio, Dividend Appreciation lost only 10% in the 2022 market debacle, when the Vanguard 500 and total market fund dropped 18% and 20%, respectively.

Another Fork in the Road?

Some readers might offer a different solution to the broad market indices’ lopsided tech problem. A person who wants to retain his S&P core could choose any one of a number of investment products to reduce the volatility of the technology overweight. To be sure, a substantial switch into a high-quality short-term bond fund would tamp down the portfolio’s peskiness. But because the largest megacap companies are overrepresented in the broad market funds’ tech holdings, that type of remedy only continues the neglect of small tech businesses.

Will I Arrive Safely?

Let’s face it, the investment world is no less susceptible to luck than politics or health. The sequence of returns is scary because it lurks at a very sensitive time on our financial journey. And, as with all short-term market spasms, we can’t control or even predict it.

But most readers don’t depend on Vanguard’s S&P 500 or Total Market fund alone, whether by means of a 60/40 or some other like-minded risk-reduction plan. This article has been just to illuminate an alternative course to ponder. We’ve saved scrupulously and invested thoughtfully and now we need a strategy to thwart a looming danger in a way that’s comfortable for ourselves and for our families.