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Sequence of Return Risk

It’s all about timing.

Investment involves risk. One category that does not get talked about often is what is called the sequence of return risk. The nutshell version is this: the risk of receiving lower or negative returns early in a period when withdrawals are made from an investment portfolio is known as sequence of return risk. If you are taking withdrawals from your portfolio, the order or the sequence of investment returns can significantly impact your portfolio’s overall value. The market is going to do what the market is going to do, and there is no way within the market to completely hedge against that volatility and risk. So even when a portfolio averages 9% over time, if you start withdrawing during a few down years, the sequence of return has a huge negative impact on what you get out of that investment portfolio.

Historically speaking, on the actual accumulation side, the sequence of return is less of a concern. That’s why investment managers are always talking about the long game. If they can demonstrate a portfolio’s performance over time, that creates an expectation, but not a promise, of steady growth. So whether you start in a down market or an up market, the historic performance of the portfolio gives you an indication of what to expect about overall performance as you invest.

Consider the following hypothetical investment scenarios for Mr. Blue and Mr. Green: Mr. Blue and Mr. Green both started out with a $750,000 investment portfolio at age 65. Both average a 9% annual return that grows to the same value after 30 years, but they experience their annual returns in inverse order from each other. See the chart below demonstrating their different paths to their ending values.

 

As you can see, in this scenario, the sequence of investment returns had no bearing on portfolio values because the average annual rate of return was the same and no distributions were taken from the account. So the sequence of return is there—the 70s are a bit of a nail-biter for Mr. Green as you can see—but overall the value turns out the same for both Mr. Blue and Mr. Green.

The sequence of return risk is present when it comes to taking withdrawals. Let’s look at how the sequence of returns can impact a portfolio when you decide to take withdrawals from the portfolio: Mr. Blue and Mr. Green still start with an initial $750,0000 investment portfolio. But in this example, they start taking 5% withdrawals (of the initial value) beginning immediately at age 65. Mr. Blue begins taking withdrawals in an up market, giving him a positive environment to maintain his portfolio value long-term. Unfortunately for Mr. Green, he starts taking income in a down market and depletes his entire portfolio before reaching age 90. Exactly what we all want to avoid.

 

So this is a very important concept to understand, especially if you are interested in building an investment portfolio. The sequence of investment returns can significantly impact your investment portfolio when taking withdrawals. It’s all about timing in a market where you have no control. So mitigating sequence of return risk needs to be about more than hoping you miss a down market when you start to withdraw from your portfolio.

The market does what the market does.

That’s why it is so important to manage this risk in retirement. You can do this by maintaining sound asset allocation strategies, product diversification, and an understanding of how best to respond to changing market conditions. Ideally, diversify in such a way that you don’t need to keep up a cycle of withdrawals during a down market. With the right plans in place well before age 65, there’s no reason to let the sequence of return risk catch you off guard.