In the world of retirement planning, the order in which you earn your investment returns can be just as important as the average return itself. This phenomenon is known as sequence of returns risk. For investors approaching or entering retirement, a poorly timed market downturn can significantly deplete a portfolio, even if the market eventually recovers. As fee-only fiduciary advisors, we believe the best defense against this risk isn’t a “get rich quick” scheme, but a disciplined, “boring” approach involving a balanced mix of stocks and bonds, rigorous stress testing, and a commitment to a long-term plan.
Executive Summary
Sequence of returns risk is the danger that a series of negative investment returns early in retirement will permanently reduce the longevity of your portfolio. Because retirees are withdrawing funds for living expenses, they are forced to sell assets at depressed prices during a downturn, preventing those assets from participating in a future recovery. You can mitigate this risk by maintaining a diversified portfolio of stocks and bonds, utilizing Monte Carlo simulations to stress-test your plan, and adhering to a systematic withdrawal strategy that avoids emotional decision-making.
What is sequence of returns risk?
Sequence of returns risk is the risk that the timing of investment returns will negatively impact the total value of a portfolio, specifically when an individual is making regular withdrawals.
While an investor in the “accumulation phase” (saving for retirement) can ignore short-term volatility, a retiree in the “distribution phase” does not have that luxury. If the market drops 20% in your first year of retirement and you still withdraw 4% for living expenses, your portfolio must work significantly harder to recover. You are essentially “locking in” losses by selling shares when prices are low.
Why do stocks and bonds both matter in a retirement portfolio?
A balanced portfolio of stocks and bonds provides a “volatility dampener” that protects your principal during market corrections while allowing for long-term growth.
Stocks are the growth engine of your portfolio, designed to outpace inflation over decades. However, they are volatile. Bonds act as the “shock absorbers.” When stock prices fall, high-quality bonds typically hold their value or even increase in price.
By holding both, you create a “bucket” of stable assets (bonds) that you can draw from during a stock market downturn. This prevents you from being forced to sell your stocks at a loss, giving your equities the time they need to rebound. Our view of investing is intentionally simple: we don’t chase “hot” sectors. We rely on a disciplined asset allocation because it works.
How does portfolio stress testing protect your retirement?
Portfolio stress testing involves simulating various “worst-case” economic scenarios to ensure your financial plan remains viable even during prolonged market crashes or high inflation.
We don’t guess about your future; we test it. By looking at historical data—such as the Great Depression, the 1970s stagflation, or the 2008 financial crisis—we can see how your specific mix of assets would have performed. If a stress test shows your portfolio has a high likelihood of failure during a repeat of the 2000-2002 tech bubble burst, we adjust your plan now, before those risks become a reality.
What is a Monte Carlo simulation in financial planning?
A Monte Carlo simulation is a mathematical technique used to estimate the probability of different outcomes in a financial plan by running thousands of “what-if” scenarios with random variables.
Instead of assuming a static 7% return every year (which never happens in real life), a Monte Carlo simulation accounts for the randomness of the market. It simulates thousands of potential paths for your retirement, including periods of high volatility and poor sequences of returns.
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The Goal: We look for a high “Probability of Success.”
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The Reality Check: It helps you understand that retirement planning is about managing probabilities, not certainties.
However, Monte Carlo simulations don’t tell you the whole story. You don’t have to be worried if your “Probability of Success” isn’t 100. All it means is that there is a chance you would have to make some adjustments to your spending. We have had a client talk to use about retiring earlier than expected. We had to explain to them that while they could meet that goal, there was a higher change that they would need to make adjustments in retirement; but there is no right or wrong answer.
Why is a “boring” investment strategy better for sequence risk?
A simple, disciplined investment strategy reduces the “behavioral gap”—the difference between market returns and what investors actually earn—by eliminating the urge to market-time.
Many investors fail because they get excited during bull markets and panicked during bear markets. By following a “boring” plan focused on low-cost index funds and a fixed rebalancing schedule, you remove emotion from the equation. When you have a plan that accounts for sequence of returns risk from day one, you don’t need to react to the daily news cycle. You simply follow the process.
How can you mitigate sequence of returns risk today?
You can mitigate sequence of returns risk by maintaining a “cash buffer,” diversifying across asset classes, and staying flexible with your spending during market downturns.
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The Cash Buffer: Keep a years worth of living expenses in low-risk accounts.
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Dynamic Spending: Be prepared to reduce “discretionary” spending (like travel) during years when the market is down.
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Regular Rebalancing: Sell a portion of your “winners” (assets that have grown) to buy more of your “losers” (assets that are undervalued), keeping your risk level consistent.
Frequently Asked Questions
What is the “Safe Withdrawal Rate”?
The safe withdrawal rate is the estimated percentage of your initial portfolio balance that you can withdraw annually, adjusted for inflation, with a high probability that the money will last 30 years. Historically, the “4% Rule” has been a common benchmark, though modern stress testing often suggests a more dynamic approach.
Does sequence of returns risk matter if I am still working?
Generally, no. If you are still contributing to your accounts, market downturns actually allow you to buy more shares at lower prices (dollar-cost averaging). The risk becomes critical only when you begin taking distributions.
How often should I stress test my portfolio?
We recommend stress testing your portfolio at least once a year or whenever you experience a major life event, such as retirement, receiving an inheritance, or a significant change in health.
What is a fiduciary financial planner?
A fiduciary is legally and ethically obligated to act in your best interest at all times. As fee-only fiduciaries, we do not accept commissions for selling products, which eliminates many conflicts of interest and ensures our advice is focused solely on your goals.