Experiencing Sequence Return Risk?

by: Steady Investor

By Zacks Investments Editorial Team

Regardless of whether you are retired or thinking about it, understanding Sequence Return Risk could be critical. The concept becomes especially important as markets turn volatile, as they are now. Here's a run-down on Sequence Return Risk so you can prepare as needed...

Why "Sequence Return Risk" is Critical for Retirees

Have you ever heard of "sequence return risk?" Don't worry -- not too many people have. But, for retirees especially, it is one of the most important considerations when it comes to how -- and when ­-- you withdraw money from your portfolio. Mismanaging your retirement income by finding yourself on the wrong end of "sequence return risk" could mean running out of money a lot faster than you think.

The Effect of Sequence Return Risk on Your Portfolio

At the heart of this risk to your retirement income is: what could happen to your portfolio if the market declines just as you start taking retirement income?

An example will help you understand the impact. Let's say you buy a stock for $10 and it drops to $5 -- that's a 50% loss. Some folks might think you only need a 50% gain to make up those losses, but you actually need more. A 50% gain on $5 would be $2.50, putting your investment at $7.50. To get back to $10, an investor would actually need a 100% gain on the $5 stock, a much larger percentage than that which drove the loss.

And that's where the trouble lies with sequence return risk. If your portfolio experiences declines early-on in your retirement, and coincides with you taking retirement income withdrawals, it becomes increasingly difficult to make up that lost ground over time. Not only do you have to recoup the market-induced losses, you also have to recoup your withdrawal rate (commonly 3%-4% of portfolio for retirees). If the market declines continue, you're nest egg will grow smaller at a faster pace, meaning you need larger gains to get back to square one. To make matters worse, many retirees mistakenly react to losses by becoming more conservative, giving them a lower chance of recouping lost capital. It can become a self-fulfilling prophecy.

How to Minimize Sequence Return Risk

You can't control where the market goes in any given year or how your portfolio will perform (unless you just remain in cash). But, what you can control is how you plan your retirement income and spending.

When it comes to retirement income, retirees should aim to be agile in two ways:

  • Cash Balances - you want your assets to be working for you, but it also makes sense to be thoughtful about how much cash you have on hand. This way, during volatile times, you can leave your portfolio alone and turn to your cash reserves to provide your income needs.
  • Spending Needs - if, during times of downside volatility, you can find ways to hunker down a bit and reign in spending, it can be very helpful in supporting the longevity of your assets.

The Bottom Line for Retirees

In bull market years, when your portfolio is doing well and the economy is growing, sticking to your retirement income plan (annual withdrawals of 4% or less, for example) should put you in good shape. It's when the market is selling off deeply or when downside volatility is lingering that you might want to consider taking pause, or to look to sources other than your investment portfolio for your income needs. The long-term upward trajectory of stocks (historically) tells us there's a near-certain chance losses can be recouped over time, so taking additional stress off your portfolio by reducing, or eliminating, withdrawals during prolonged downturns can provide additional recovery support to recoup those losses faster.

Disclosure: Past performance is no guarantee of future results. Inherent in any investment is the potential for loss.

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