Sequence of Return Risk: Understanding its Impact on Your Investments

Sequence of Return Risk: Understanding its Impact on Your Investments

Sequence of Return Risk is a concept that every investor should understand, especially those who are planning to invest for the long-term. This risk refers to the possibility of receiving lower investment returns when assets are withdrawn in a specific order or sequence. In this article, we will dive deeper into this topic, exploring what sequence of return risk is, and how it can impact your investments.

What is Sequence of Return Risk?

Sequence of Return Risk is a financial risk that is associated with the order in which investment returns are received. This risk can lead to different investment outcomes for investors facing the same volatility. In other words, it is the risk that investors face when they start withdrawing funds from their portfolio during a down market.

The impact of this risk can be significant, particularly for retirees who rely on their investment portfolios for income. In such a scenario, the order of returns can determine the sustainability of retirement income. For instance, if a retiree experiences negative returns during the early years of their retirement, they could end up with less money than they had anticipated, leading to significant lifestyle changes.

Understanding the impact of Sequence of Return Risk

To better understand the impact of Sequence of Return Risk, let us consider an example. Let’s assume that we have two investors who start investing $10,000 annually in the global index ETF, VT. The first investor invests from 2008 to 2021, while the second investor invests in reverse order, i.e., from 2021 to 2008. The investment results are as follows:

Investor A (Normal Return Sequence)

Investment period: 2008 to 2021

Total investment: $140,000

Accumulated assets by the end of 2021: $345,509

Annualized return rate: 11.41%

Investor B (Reverse Return Sequence)

Investment period: 2021 to 2008

Total investment: $140,000

Accumulated assets by the end of 2021: $220,000

Annualized return rate: 5.84%

As we can see, despite investing the same amount of money, the sequence in which the returns were realized made a significant difference in the final investment outcome. The return sequence can have a significant impact on the growth and sustainability of a portfolio.

Why does Sequence of Return Risk occur?

Sequence of Return Risk occurs because of the way that compound interest works. In a normal return sequence, early positive returns help to create a larger base for future returns to compound upon. In contrast, if an investor experiences negative returns early in their investment period, the compounding effect works against them. Even if the investor experiences positive returns later, the gains may not be enough to offset the losses incurred during the initial period.

How can investors mitigate Sequence of Return Risk?

Investors can take several steps to mitigate the risk of Sequence of Return. One way is to avoid taking large withdrawals during bear markets. By avoiding withdrawals during down markets, investors can allow their portfolios to recover from any losses incurred during the downturn.

Another way to mitigate Sequence of Return Risk is to diversify your portfolio. Diversification can help to spread risk across different asset classes, reducing the impact of negative returns in any single investment.

Finally, investors can also consider investing in annuities or other guaranteed income products. These products can provide a guaranteed stream of income that is not subject to market fluctuations.

Sequence of Return Risk is a crucial concept for long-term investors to understand, particularly those who rely on their investment portfolios for income. The order in which investment returns are received can significantly impact the growth and sustainability of a portfolio. To mitigate the risk of Sequence of Return, investors can avoid taking large withdrawals during bear markets, diversify their portfolios, and consider investing in annuities or other guaranteed income products. By taking these steps, investors can help ensure that their portfolios remain resilient, even during periods of market volatility.