Investing in the stock market can be a rewarding way to grow your wealth over time. However, it’s important to be aware of the risks involved, especially when it comes to the sequence of returns. Sequence of return risk is a concept that every investor should understand in order to protect their investments and achieve their long-term financial goals. In this quarterly newsletter, we will explore what sequence of return risk is, why it matters, and strategies to mitigate its impact.
What is Sequence of Return Risk?
Sequence of return risk refers to the impact of the order in which investment returns are realized. In other words, it’s not just the average annual return that matters, but the timing of those returns. If an investor experiences poor returns during the early years of retirement when they are making withdrawals from their portfolio, it can significantly impact their overall portfolio balance and potentially lead to running out of money sooner than expected.
Why Does Sequence of Return Risk Matter?
Sequence of return risk matters because it can have a profound impact on the success of your retirement plan. Consider two scenarios:
- Positive sequence of returns: If an investor experiences strong market performance during the initial years of retirement, their portfolio grows significantly, and they have more flexibility when it comes to making withdrawals. This positive sequence of returns can help sustain their portfolio throughout retirement.
- Negative sequence of returns: On the other hand, if an investor experiences poor market performance during the early years of retirement, their portfolio may suffer significant losses. This forces them to withdraw from a smaller portfolio balance, which can accelerate the depletion of their savings and put their retirement at risk.
Strategies to Mitigate Sequence of Return Risk
While sequence of return risk cannot be completely eliminated, there are strategies that investors can employ to mitigate its impact. At Holistic Planning, we employ these strategies, discussed below, to help minimize the potential impact of sequence of return risk.
- Diversification: A well-diversified portfolio can help reduce the impact of poor market performance in any one asset class or sector. By spreading your investments across different asset classes, such as stocks, bonds, and other asset types you can potentially cushion the blow of negative returns in one area.
- Asset Allocation: Asset allocation is the process of determining the right mix of investments that align with your risk tolerance and goals. By diversifying your portfolio across different asset classes, you can balance the potential risks and rewards, reducing the impact of a negative sequence of returns.
- Withdrawal Strategy: Implementing a smart withdrawal strategy can help navigate sequence of return risk. One such strategy is the “bucket approach,” where you divide your portfolio into different buckets based on time horizons. The short-term bucket consists of cash and other stable investments to cover immediate expenses, while the long-term bucket is invested for growth.
- Flexibility in Spending: Having flexibility in your retirement spending can help mitigate the impact of a negative sequence of returns. Consider adjusting your lifestyle and spending habits during periods of poor market performance to preserve your portfolio and give it time to recover.
Sequence of return risk is an important concept for investors to understand, especially those planning for retirement. By being aware of this risk and implementing strategies to mitigate its impact, you can protect your investments and increase the likelihood of achieving your long-term financial goals. Remember, investing is a long-term journey, and careful planning and risk management are essential to weather any market volatility that may come your way.