Sequencing risk, also known as "sequence of returns risk," is a risk that is unique to retirement savings and investment portfolios. It refers to the risk that the timing of returns on an investment portfolio can significantly impact the portfolio's overall performance, particularly during the early years of retirement when withdrawals from the portfolio are likely to be the highest.
For example, imagine two investors with the same investment portfolio with the same expected return and risk level. Investor A retires in a year when the market is experiencing a bull market, and their portfolio is performing well, while Investor B retires in a year when the market is in a bear market, and their portfolio is performing poorly. Despite having the same portfolio, Investor A is likely to have a much better retirement outcome than Investor B because of the sequencing of returns.
Sequencing risk can be particularly challenging for retirees because they are more likely to withdraw funds from their portfolios while markets are experiencing downturns. This can lead to a situation where retirees are forced to sell assets at a loss to meet their withdrawal needs, which can significantly reduce the overall value of their portfolios.
To mitigate sequencing risk, investors can consider several strategies:
- One strategy is to use a "bucket" approach, where a portion of the portfolio is allocated to cash and bonds, which can be used to provide income during market downturns.
- Another strategy is to use a "glide path" approach, where the portfolio gradually shifts from a higher equity allocation to a lower one as the investor approaches retirement. This can reduce the portfolio's overall volatility during the early years of retirement.
- Additionally, investors can consider using annuities or other income-generating products to provide a steady income stream during retirement. This can reduce the need for withdrawals from the portfolio during market downturns and thereby reduce sequencing risk.
Overall, sequencing risk is essential for investors nearing retirement. By understanding this risk and taking steps to mitigate it, investors can help to ensure that their portfolios can support them throughout their retirement years.