Sequence risk, or sequence of returns risk, has to do with the order in which your investment returns occur. It is something you experience when you transition into needing to draw income from your investments. When you are in the accumulation or savings stage, sequence risk does not affect you.
The best way to understand sequence of returns risk is with an example.
Accumulation – No Sequence of Returns Risk
Suppose you invested $100,000 in 1996, in the S&P 500 Index. Below are the index returns.
- 1996 23.10%
- 1997 33.40%
- 1998 28.60%
- 1999 21.0%
- 2000 -9.10%
- 2001 -11.90%
- 2002 -22.10%
- 2003 28.70%
- 2004 10.90%
- 2005 4.90%
Your $100,000 grew to $238,673. Not bad.
Withdrawing Income – Same Returns
Now suppose, instead of the above scenario you retired in 1996. You invested $100,000 in the S&P 500 Index, and you withdrew $6,000 at the end of each year. Over the ten years you received $60,000 of income and you have $162,548 left. Add those two up and you get $222,548.
Returns Occur in the Opposite Order
Now suppose you retired in 1996, but the returns listed above happened in the exact opposite order, as shown below.
- 1996 4.90%
- 1997 10.90%
- 1998 28.70%
- 1999 -22.1%
- 2000 -11.90%
- 2001 -9.10%
- 2002 21.0%%
- 2003 28.60%
- 2004 33.4%%
- 2005 23.10%
(Additional returns data available in historical market returns.)
If you were not yet retired, and you invested the $100,000 in 1996, even though the returns occurred in the opposite order, you ended up with the same amount of money: $238,673. Because you were in the accumulation phase, the change in the sequence of returns did not affect you.
However, if you were withdrawing income the change in the sequence in which the returns occurred did affect you. If you retired in 1996, invested $100,000 and withdrew $6,000 at the end of each year, at the end of the ten years you received $60,000 of income and have $125,691 left. Add the two together and you get $185,691. Not bad, but not as good as the $222,548 you would have received if the returns had happened the other way around.
Over the course of your retirement years if a high proportion of negative returns occur in the beginning years of your retirement, it will have a lasting negative effect and reduce the amount of income you can withdraw over your lifetime. This is called sequence of returns risk.
You do not have this risk until you are withdrawing money on a regular basis. When you are in the savings phase, if the negative returns occur early or late, it doesn’t matter, you still get to the same ending account balance over time.
When retired, it does matter, because you need to be selling investments periodically to support your cash flow needs, and if the negative returns occur first, you end up selling some holdings, reducing the shares you own that are available to participate in the later-occurring positive returns.
Sequence of Returns Risk is Somewhat Like Dollar Cost Averaging in Reverse
Sequence of returns risk is somewhat the opposite of dollar cost averaging. With dollar cost averaging you invest regularly and buy more shares when investments are down. When you are taking income, you are selling regularly, and you need to have a plan in place to make sure you aren’t forced to sell too many shares when investments are down.
Protecting Yourself from Sequence Risk
Having a disciplined investment process in place can help manage sequence risk. Withdrawal Rate Rules for Creating Retirement Income provides six rules that you would be wise to follow when investing for retirement income.
Another option is to use investments that provide guaranteed income. 7 Ways to Build a Floor of Guaranteed Retirement Income will give you some ideas on how to approach this.
Another option is to create a laddered bond portfolio, so that each year a bond matures to meet your current cash flow needs. In this way the equity portion of your portfolio is in essence still in the accumulation phase, and you can choose to harvest gains from it to buy more bonds in years during or after strong stock market returns.
The best thing you can do is understand all choices involve a trade off between risk and return. Develop a retirement income plan, follow a time-tested disciplined approach, add a little flexibility, and you will be in good shape.