When planning for financial stability, one often-overlooked factor can make or break your long-term investment success: sequence of returns risk. While many focus solely on average returns, the order in which those returns occur plays a crucial role, especially during retirement and the accumulation phase of investing. If you’re unfamiliar with this silent but significant risk, understanding it could be the difference between a thriving retirement and financial shortfalls.
What Is Sequence of Returns Risk?
Sequence of returns risk refers to the impact that the order of investment returns has on a portfolio’s overall performance. Even with the same average annual return, the sequence of those returns can lead to vastly different outcomes, depending on when losses or gains occur.
Let’s break it down:
- During Retirement: If your portfolio suffers significant losses early in retirement, those losses can rapidly deplete your savings—especially if withdrawals are occurring simultaneously.
- During Accumulation: Early poor returns can shrink your portfolio’s growth base, leading to reduced compounding over time.
Simply put, sequence of returns risk can have lasting financial consequences, even if your portfolio achieves the same average return as someone else’s.
Why Average Returns Are Misleading
It’s easy to assume that an average return tells the whole story. For example, a portfolio that averages a 6% return annually over 30 years might sound reliable. However, if significant losses occur early, they can drastically impact the portfolio’s longevity and growth potential.
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The Impact of Sequence of Returns Risk on Retirement Portfolios
For retirees, sequence of returns risk is particularly dangerous. When you’re withdrawing money from your portfolio, early losses leave less capital to recover during market rebounds. Over time, this can lead to premature portfolio depletion.
Example: Retiree Scenarios
Imagine two retirees, each starting with $1,000,000 and withdrawing $50,000 annually:
- Retiree A: Experiences a 20% portfolio loss in Year 1.
- Retiree B: Experiences the same 20% loss, but in Year 10.
Despite having the same average return over time, Retiree A ends up with far less savings than Retiree B because early losses reduced the capital available for compounding. This is why sequence of returns risk is often called the silent killer of retirement plans.
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Why Sequence of Returns Risk Matters During Accumulation
While this risk is most frequently associated with retirees, it also impacts those in the accumulation phase. Here’s how:
- Early Losses: Poor market performance during the first few years of investing reduces your portfolio’s base, compounding over time into significantly smaller returns.
- Delayed Growth: Recovering from early losses takes time, meaning your portfolio has fewer years to capitalize on market rebounds.
To illustrate, consider two investors:
- Investor A: Experiences strong returns in their first five years, followed by lower returns later.
- Investor B: Experiences poor early returns, followed by strong gains later.
Even with the same average return, Investor A ends up with a significantly larger portfolio due to their early gains compounding over time.
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Examples of Sequence of Returns Risk
Let’s take a closer look at how the order of returns impacts a $1,000,000 portfolio:
Scenario A: Positive Returns First
- Year 1: +10%
- Year 2: +8%
- Year 3: -10%
Average Return: 2.7%
Ending Value After Withdrawals: $980,000
Scenario B: Negative Returns First
- Year 1: -10%
- Year 2: +8%
- Year 3: +10%
Average Return: 2.7%
Ending Value After Withdrawals: $910,000
Even with the same average return, Scenario B ends up with $70,000 less due to the sequence of returns.
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Mitigating Sequence of Returns Risk
While the risks are real, there are proven strategies to protect your portfolio from the harmful effects of sequence of returns risk. Here’s how:
1. Diversify Beyond Market-Based Investments
Relying exclusively on stocks and bonds leaves your portfolio exposed to market volatility. Incorporating alternative investments, such as income-generating real estate or collateral-backed strategies, can reduce reliance on unpredictable returns.
2. Establish a Guaranteed Income Stream
Tools like annuities and dividend-paying whole life insurance can provide stable, predictable income during retirement, reducing the need to withdraw from market-dependent portfolios during downturns.
- Annuities: Offer guaranteed lifetime income that’s unaffected by market fluctuations.
- Whole Life Insurance: Builds cash value over time, providing liquidity and stability when markets are volatile.
3. Maintain a Cash Reserve
A cash reserve acts as a buffer, allowing you to cover expenses without tapping into a declining portfolio. This prevents locking in losses during market downturns.
4. Build a Strategy for Risk Mitigation
Work with a financial strategist to design a diversified portfolio that balances growth and stability. This includes incorporating guaranteed returns alongside growth-oriented investments to ensure resilience across market conditions.
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The Role of Guaranteed and Collateral-Backed Returns
At the heart of mitigating sequence of returns risk is the concept of guaranteed and collateral-backed investments. These provide predictable returns regardless of market conditions, creating a stable foundation for your financial plan.
Key Strategies
- Annuities: Guarantee income for life, ensuring you’ll never outlive your money.
- Dividend-Paying Whole Life Insurance: Offers tax-free cash value access and stable growth over time.
- Real Estate Notes: Provide consistent, collateral-backed income streams that are less correlated to market fluctuations.
By incorporating these strategies, you can effectively mitigate sequence of returns risk and build a financial plan that prioritizes long-term stability.
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Final Thoughts: Planning for Stability
Sequence of returns risk is an often-overlooked factor that can derail even the most well-thought-out financial plans. Whether you’re in the accumulation phase or nearing retirement, protecting your portfolio from early losses is critical to ensuring long-term success.
By diversifying your investments, creating guaranteed income streams, and incorporating collateral-backed strategies, you can shield your finances from the damaging effects of sequence of returns risk. With the right plan in place, you’ll enjoy greater peace of mind and a more secure financial future.
Take the Next Step
Ready to safeguard your financial future from sequence of returns risk? Contact SureWealth Solutions today for a complimentary consultation. We’ll help you develop a personalized strategy tailored to your unique needs, ensuring stability, growth, and peace of mind throughout your financial journey.