What is sequence risk and how might it impact your retirement planning?
What is sequence risk? It’s the risk you’ll encounter rough markets with negative investment returns when you first retire. This can have a significant impact on your ability to spend during the rest of your retirement years.
Briefly, here’s how sequence risk works. During your career, when you’re still building wealth, market downturns give you the chance to buy more shares of stocks and bonds than you can when prices are higher. When the market recovers, you then have more shares to recover with. This ultimately increases the value of your portfolio. (This is why you should be glad when markets tank during your saving years.)
But then you stop working, and start spending your reserves. When stock markets decline, you will need to sell shares at lower prices. This means you’ll have to sell more of them to withdraw the same amount of cash. The market is expected to eventually recover, but your portfolio will have fewer shares with which to participate in the recovery.
Here’s another way to wrap your head around sequence of returns: If markets are down when you first retire and up in later years, your average return over time may be acceptable. But the early reduced shares balance means a lower future portfolio balance. Again, this may require an unwelcome reduction in future retirement spending.
To mitigate the effect of bad markets early in retirement, it is critical to construct your investment portfolio to reduce the chance of extreme drops in value, because very low investment values will require many more shares to be sold than desired.
That said, most retirees need a growth component to their retirement portfolio. For this, you must hold stocks, which are volatile by nature. But you also need less-volatile bonds, to reduce overall portfolio volatility. You likely also need alternative investments such as real estate and commodities.
To be frank, it’s hard to design a portfolio with the right mix of growth opportunities for the up years and stability for the down ones, especially without proper training, experience and software. A trip to a financial planner for help would be a smart move.
John A. Frisch, CPA/PFS, CFP®, AIF®, PPC™ founded Alliant Wealth Advisors in 1995 and has over 30 years of experience as a financial professional. In his free time, he’s an avid long-distance runner, a sport that requires discipline, patience and vision. John applies these same skills to his professional pursuits: He helps families and retirement plan sponsors adopt a patient, disciplined approach to overcoming financial challenges and reaching their distant goals along a clear path. Learn more at www.alliantwealth.com.