Sequence-of-returns risk, or sequence risk, is the risk that an investor will experience negative portfolio returns very late in their working lives and/or early in retirement.
The risk of receiving lower or negative returns early in a period when withdrawals are made from an investment portfolio is known as sequence of return risk. If you are taking withdrawals from your portfolio, the order or the sequence of investment returns can significantly impact your portfolio’s overall value.
The 4% rule is a rule of thumb that suggests retirees can safely withdraw the amount equal to 4 percent of their savings during the year they retire and then adjust for inflation each subsequent year for 30 years. The 4% rule is a simple rule of thumb as opposed to a hard and fast rule for retirement income.
How to Mitigate Sequencing Risk
- Build buffers into your portfolio so there’s no need to sell during downturns.
- Contribute larger amounts early on if possible.
- Monitor returns.
- Adjust asset allocations at appropriate times.
- Adjust spending levels if required (if you are able to meet your income needs elsewhere).
When the Coronavirus pandemic emerged and stock markets fell in March 2020 I advised a number of clients to lower their attitude to investment risk and reduce their income withdrawals from their portfolios. Many clients followed my advice. This action resulted in greater preservation of their capital.
Over the last two years, most clients have reverted to their previous higher levels of investment risk and restored their previous income withdrawal levels. This is proving to be a successful approach because stock markets appear to be recovering over the last few weeks after six months of poor performance.
Another favoured strategy is to phase investment over, say, 3 or 6 months, by investing a third or a sixth of the money monthly in order to reduce the risk of investing all of your money just before a stock market crash. If the market does fall then you are investing at an average price over the phasing time period. This is known as pound cost averaging.
So the key to managing your sequencing risk is being flexible and open-minded about changing track in the short term if markets suddenly turn against you. That way you preserve your capital better. You know it makes sense.*
*The value of your investment can fall as well as rise and is not guaranteed. The contents of this blog are for information purposes only and do not constitute individual advice. You should always seek professional advice from a specialist. All information is based on our current understanding of taxation, legislation, regulations and case law in the current tax year. Any levels and bases of relief from taxation are subject to change. Tax treatment is based on individual circumstances and may be subject to change in the future. This blog is based on my own observations and opinions.