Sequence of returns risk, also known as "order risk" or "timing risk," is a type of risk that occurs in the context of retirement planning. It refers to the potential negative impact on a retirement portfolio's performance caused by fluctuations in the market during specific periods of time.
For example, consider two investors who both retire at age 65 with a portfolio of $500,000. Investor A experiences steady, moderate returns for the first 10 years of retirement, while Investor B experiences a market downturn early on, followed by a recovery over the same time period. Despite both investors having the same portfolio size and experiencing the same overall returns over the 10-year period, Investor A may end up with significantly more wealth due to the timing of the returns. This is because Investor A had the opportunity to reinvest their gains at higher prices, while Investor B had to weather the downturn and potentially sell at a loss.
Sequence of returns risk can have a significant impact on an investor's ability to sustain their retirement income, as it can affect both the amount of money they have available to withdraw and the rate at which they can withdraw it. For example, if an investor experiences a market downturn early on in retirement, they may be forced to sell off a portion of their portfolio at a loss in order to meet their withdrawal needs. This can reduce the overall size of the portfolio and limit the investor's ability to recover from the downturn.
There are a few key strategies that investors can use to mitigate sequence of returns risk in retirement. One approach is to diversify the portfolio by including a mix of asset classes, such as stocks, bonds, and cash. This can help to smooth out returns over time and reduce the impact of market downturns on the portfolio.
Another strategy is to adopt a "bucket approach," where the retirement portfolio is divided into separate "buckets" with different investment strategies. For example, one bucket might consist of conservative investments, such as cash and fixed income, that can provide a steady stream of income during retirement. Another bucket might be more aggressive, with a higher allocation to growth-oriented investments like stocks. This approach can help to balance the need for growth and income in retirement, while also providing a degree of flexibility to adjust the portfolio in response to market conditions.
Investors can also consider using tools like annuities to provide a guaranteed stream of income in retirement. Annuities can be structured in a variety of ways, such as fixed annuities, which offer a fixed payment for a set period of time, or variable annuities, which allow investors to choose from a range of investment options. While annuities can provide a measure of security in retirement, they may also come with fees and restrictions, so it is important to carefully consider all of the available options before making a decision.
In addition to these strategies, it is also important for investors to have a clear plan for managing their retirement income. This may involve setting a realistic budget and developing a withdrawal strategy that takes into account both the investor's needs and the performance of their portfolio. By taking a proactive approach to managing their retirement income, investors can help to minimize the impact of sequence of returns risk on their retirement plan.
In conclusion, sequence of returns risk is an important consideration for investors planning for retirement. By diversifying their portfolio, adopting a bucket approach, and carefully planning their withdrawal strategy, investors can help to mitigate the impact of market fluctuations on their retirement income. While no one can completely eliminate sequence of returns risk, these strategies can help investors to better manage it and increase their chances of achieving a secure and comfortable retirement.