It’s possible you think about your investments and retirement planning once in a while and don’t fully understand what you’re doing….
If so, you’re not alone.
Many people shy away from finance because it’s confusing. This is especially true when it comes to the sequence of returns. But don’t worry, we’re here to help!
This article will discuss everything you need to know about the Sequence of Returns:
- what it is
- how it’s calculated
- how it affects your wealth.
We’ll also provide tips on managing your investments to minimize the risk associated with the Sequence of Returns.
So, what is the Sequence of Returns?
In simple terms, it’s the order in which you experience returns on your investment.
For example, let’s say you have two investments:
- Investment A grows by 20% in Year One and then loses 15% in Year Two.
- Investment B loses 15% in Year One and then increases by 20% in Year Two.
While both investments have the same return over the two years (i.e., they both grew by five percent), their order of returns is different.
The difference is what’s known as the Sequence of Returns.
The Sequence of Returns can have a significant impact on your wealth, especially when it comes to retirement planning.
This is because the order in which you experience returns affects how long your money lasts.
For example, let’s say you retire with a portfolio of $500,000 and plan to withdraw $50,000 per year to cover expenses.
If you have a Sequence of Returns like Investment A above (i.e., 20% growth followed by 15% loss), your ending balance is $417,500 (assume you withdrawal dec 31st)
Year 1 balance $500,000 + $100,000 (20%) – $50,000 = $550,000
Year 2 balance $550,000 – $82,500 (-15%) -$50,000 =$417,500
However, if you have a Sequence of Returns like Investment B (i.e., 15% loss followed by 20% growth), your ending balance is
Year 1 balance $500,000-$82,500(-15%)-$50,000= $367,500
Year 2 balance $367,000 +73,500(20%)-$50,000= $390,500
In other words, the order of returns can significantly impact how long your money lasts in retirement.
How Sequence of Returns Affect Your Wealth
Making withdrawals in down years can compound your losses.
This is why it’s essential to build a cash buffer in retirement. In the years the market returns a positive number it’s easier/better to withdraw from that account. However, in a down year, you should consider pulling money out of a cash positive instead. This should give your portfolio time to recover.
It also has an impact on your ability to reach your other financial goals.
For example, let’s say you’re saving for a down payment on a house.
It will take longer to reach your goal if you experience a period of loss early on.
On the other hand, if you experience a period of gains early on, you’ll be able to reach your goal more quickly.
Strategies to Mitigate the Risks Associated with the Sequence of Returns
A few strategies can help mitigate the risk associated with the Sequence of Returns.
1. Invest regularly
This helps to smooth out the ups and downs of the market and can help reduce the impact of the Sequence of Returns.
For example, let’s say you invest $100 per month into a stock currently trading at $50 per share.
If the stock goes down to $40 per share, you’ll be buying more shares (i.e., you’ll be dollar cost averaging).
As a result, your average cost per share will be lower, and you’ll be in a better position when the stock price eventually recovers.
Investing regularly is one of the best ways to mitigate the risk associated with the Sequence of Returns.
2. Invest in a diversified portfolio
This is another effective strategy for mitigating the risk associated with the Sequence of Returns.
A diversified portfolio includes asset classes, such as stocks, bonds, and cash.
The idea is to invest in various assets to make your portfolio less volatile.
For example, let’s say you have a portfolio invested entirely in stocks.
If the stock market crashes, your portfolio will likely lose much value.
However, suppose you have a diversified portfolio with other asset classes like bonds and cash. In that case, your portfolio will be less volatile and more likely to weather the storm.
Diversification is one of the most important aspects of investing, and it’s an effective way to mitigate the risk associated with the Sequence of Returns.
3. Invest for the long term
This is another effective strategy for mitigating the risk associated with the Sequence of Returns.
The idea is to invest for the long term so that you’re less likely to be affected by short-term market fluctuations.
For example, let’s say you’re saving for retirement and have a time horizon of 30 years.
Even if the stock market crashes and you experience a period of losses, you’ll still have time to recover before you need to start withdrawing from your account.
Investing long-term is a great way to mitigate the risk associated with the Sequence of Returns.
4. Build a cash buffer
For retirement you should look to have 2-3 years of income needs in a cash or short term bond position. This will give you the necessary buffer from withdrawing money from negatively performing investmetns.
For non-retirement goals, once you get within 2 years of needing the money-you should look to make your investments more conservative so they aren’t subjected to the swings of the market. By doing both of these things you can avoid being affected by poor sequence of returns.
The Bottom Line
The Sequence of Returns is an important concept that every investor should understand.
It’s a risk that can significantly impact your wealth, but there are strategies you can use to mitigate the risk.
Investing regularly, investing in a diversified portfolio, building cash, and investing for the long term are all effective strategies for mitigating the risk associated with the Sequence of Returns.
If you’re not sure where to start, we can help. We offer various services designed to help you reach your financial goals. Contact us today to learn more.
Leave me a message at jared@redwoodplanning.com, I’ll respond the same day.
