As people look ahead to retirement, they often picture relaxing days, trips, and special times with family and friends. However, a financial issue is not always so obvious, and it can significantly impact how secure your retirement is. It’s called the sequence of returns risk. This aspect of retirement planning is easy to miss, but it can make a real difference in whether your financial future is successful.
What is the sequence of returns risk?
The sequence of returns risk, sometimes called “sequence risk,” is the idea that the order in which your investments perform, combined with the timing of your withdrawals, can significantly affect how long your retirement savings will last and their ability to bounce back from setbacks. This isn’t just a theoretical concern but a real challenge that can significantly impact your financial security, especially if you’re on the verge of retirement or depend on your investments to cover your living expenses.
While it’s normal for the stock market to go up and down, facing negative returns early in retirement can seriously affect your long-term financial plans. This happens because when you take money out of your retirement accounts to pay for your living expenses, you might end up selling your investments when their value is lower due to a down market. If you’re forced to sell a substantial portion of your assets to meet your financial needs during a market downturn, you could miss out on potential future market gains when things eventually improve.
To make matters more challenging, losses in your investments can have a compounding effect that takes time to bounce back from. For instance, if you have a 20% loss in one year, you’d need a 25% gain the next year to return to where you started. And if you’re taking money out of your portfolio during this time, you’d need an even higher return to cover your expenses and get your finances back on track.
Ways to mitigate sequence of returns risk
During retirement, the last thing you want is to wake up every day anxious about what’s happening in the stock market. Although you can’t eliminate the sequence of returns risk, you can take actions to reduce some of the risks and position yourself to handle market downturns without having to sell your investments when they’re at a loss.
1. Utitlize a 60/40 portfolio
A 60/40 portfolio is a popular strategy that balances risk and returns, suitable for many, especially those concerned about retirement funds. It divides investments into 60% stocks, with higher potential returns but more volatility, and 40% bonds, safer but with lower returns. Bonds create a safety cushion for tough times, stabilizing your portfolio when stocks drop. This approach helps manage market ups and downs during retirement, offering stability, consistent income, and confidence in your financial goals.
2. Have a cash buffer
It’s essential to have some cash saved up for emergencies to lessen the sequence of returns risk. This cash can be helpful when the stock market is down because you can use it to pay your bills instead of selling your investments when their value is low. Financial experts often suggest keeping enough money to cover your living expenses in cash for one to two years or easily cashed-in investments. This cash stash acts like a safety net during tough times and gives your investment portfolio a chance to bounce back.
3. Asset allocation
Asset allocation is a powerful tool to counter the sequence of returns risk during retirement. It involves spreading your money across different types of investments, like stocks, bonds, and cash, which have varying levels of risk and return. By diversifying in this way, you can reduce the impact of market ups and downs. As you near retirement, you can adjust your allocation to be more cautious, with a higher proportion of stable assets like bonds and cash. This shift helps protect your portfolio from big market drops when you start depending on it for income. Plus, a well-planned allocation can provide regular income from bonds and other assets, reducing the need to sell investments when the market is down. This long-term approach also helps you stay on track and avoid emotional reactions to short-term market changes, safeguarding your financial well-being throughout retirement.
Conclusion
The sequence of returns risk can significantly challenge your retirement plans. However, you can fortify your financial security and weather market volatility during retirement by adopting strategies like the 60/40 portfolio, maintaining a cash buffer, and implementing intelligent asset allocation. These tactics provide stability, consistent income, and a long-term perspective, helping you navigate the ups and downs of the financial landscape with confidence, ultimately securing your retirement dreams. If you have any questions or concerns with the sequence of returns, CF Financial may be able to help.