If you intend to use money in your portfolio to buy a home, afford a wedding, or maybe you are getting ready for retirement, one financial concept you need to be acquainted with is sequence of returns risk. This term refers to the uncertainty and potential impact that the order of investment returns can have on your portfolio, especially as you begin to make withdrawals. This is a very common risk however it becomes particularly significant in the years surrounding your retirement, as the timing of good and bad returns can greatly influence the longevity of your retirement savings as you will be continuously withdrawing from your portfolio compared to other life events.
Unlike the average returns over time, which may appear stable, the sequence of those returns can vary greatly and is unpredictable. For instance, experiencing negative returns early in retirement can deplete your savings faster than if those returns occurred later on. This risk is heightened by the fact that, during retirement, you are no longer contributing to your savings but are instead relying on them for income. Understanding how the sequence of returns affects your retirement is critical to effective retirement planning and portfolio management.
Key Takeaways
- Recognize the importance of sequence of returns risk on retirement savings.
- Early negative returns can disproportionately impact the longevity of savings.
- Effective retirement planning requires an understanding of this risk.
Understanding Sequence of Returns Risk
I found this video from what appears to be a father and son wealth management firm called Carlin Financial Group, I am by no means affiliated with them but their video on sequence of returns risk is a great visualization of the potential dilemma that anyone can find themselves in without being well prepared.
When planning for retirement, one of the risks you might face is sequence of returns risk. This risk involves the timing of when you receive investment returns, and it can substantially affect the longevity of your retirement savings.
Why It Matters:
- If significant investment losses occur early in retirement, they can diminish the overall size of your portfolio more than if they occur later on.
- Withdrawals made during a market downturn exacerbate this effect, as you’re selling investments at lower values.
Here’s what you need to know:
- Retirement Phase: When you transition from accumulating assets to withdrawing income, the sequence of returns becomes critical.
- Diversification: It’s essential to diversify your investments to mitigate sequence of returns risk. This means spreading your assets across various investment types.
Risk Mitigation Strategies:
- Asset Allocation: Adjust your asset allocation to include a mix of stocks, bonds, and other asset classes.
- Withdrawal Strategy: Consider flexible withdrawal rates and have a buffer in the form of cash or low-risk investments.
- Timing: Delay withdrawals from impacted investments during market downturns, if possible.
Understanding this concept and preparing for it should be a key part of your retirement planning and investing strategy. Remember, by managing sequence of returns risk effectively, you can make significant strides in preserving your retirement income for the long haul.
Impact on Retirement Savings
When you enter retirement, sequence of return risk can significantly influence how long your savings will last. This risk is amplified if market downturns occur early in your retirement when you start making withdrawals.
Timing and Withdrawal Rates
It’s essential to understand the timing of your withdrawals and how they interact with market fluctuations. If you begin taking out money during a market downturn, your portfolio might not have sufficient time to recover. This makes the sequence risk, or the order in which returns occur, a critical factor for you to consider. Aligning your financial plan with a safe withdrawal rate can help mitigate this risk.
For instance, the commonly cited 4% rule advises that you can safely withdraw 4% of your retirement plan in the first year, followed by “inflation-adjusted amounts” in subsequent years. Remember, these are guidelines, not guarantees.
Savings Depletion Risk
One of the gravest concerns for you as an investor is the risk of depleting your savings too early. This is often referred to as savings depletion risk. A market dip coinciding with high annual withdrawals can accelerate the decline of your retirement portfolio’s balance, potentially leading to its premature exhaustion.
It is important for your retirement plan to have enough flexibility to adjust withdrawal rates during poor market performance. By actively managing your withdrawal strategy, you may protect your savings against the unpredictable nature of financial markets.
Strategies to Mitigate Risk
In the context of financial planning, particularly as you approach or enter retirement, managing sequence of return risk is crucial to safeguard your portfolio value. By adopting specific strategies, you can help cushion your investments against the impact of poor timing and unfavorable market conditions.
Asset Allocation and Diversification
Asset allocation is key to creating a diversified portfolio. A balanced mix of stocks, bonds, and other assets can help to stabilize your portfolio. An effective investment strategy typically includes diversifying across various sectors and geographies to minimize risk. If you’re heavily weighted in stocks during a market downturn, the sequence of return risk could significantly reduce your portfolio’s value as shown in the video above. By including a variety of asset types, such as bonds or annuities, which tend to be less volatile, you’re better positioned to weather financial storms.
Bonds are much more risk adverse asset class, I recently put out an article on I Bonds that you should check out if you are nearing retirement to see if they align with your financial goals as you near retirement.
Portfolio Rebalancing
Regular portfolio rebalancing is essential to maintaining your desired asset allocation. Over time, some investments may outperform others, leading to a drift from your initial allocation percentages. By rebalancing, you can sell overperforming assets and purchase others to maintain a balanced, diversified approach. This discipline ensures that you are not overexposed to the risks associated with any single asset class.
Alternative Income Sources
Consider developing alternative income sources to reduce reliance on your investment portfolio, especially in the early years of retirement. This might include rental income, part-time work, or an annuity that provides a steady income stream. Structuring your finances to have these alternative sources can significantly diminish sequence of return risk, as you won’t need to draw down as heavily on your investments during a market downturn.
By collaborating with a financial advisor and employing these strategies, you can craft a robust approach to retirement planning that minimizes the sequence of return risk and promotes long-term financial health.
Closing Thoughts on Sequence of Returns Risk
Sequence of returns risk is a very common risk in retirement but also a risk to keep in mind for when you are anticipating deploying capital such as for a home or other big life event. I believe retirement is the most common point in one’s life where they will need to keep in mind of this portfolio risk, but it is important to be aware of as you wind down from the growth stage to the wealth preservation stage in life.