Knowledgeable investors are aware that investing in the capital markets presents any number of risks – interest-rate risk, company risk, and market risk. Risk is an inseparable companion to the potential for long-term growth. Some of the investment risks we face can be mitigated through diversification.1
As an investor, you face another, less-known risk for which the market does not compensate you, nor can it be easily reduced through diversification. Yet, it may be the biggest challenge to the sustainability of your retirement income. Financial outcomes can be dramatically different depending on when and how a person begins their retirement days.
This risk is called the sequence-of-returns risk.
The sequence-of-returns risk refers to the uncertainty of the order of returns an investor will receive over an extended period of time. As Milton Friedman once observed, you should, “Never try to walk across a river just because it has an average depth of four feet.”2
Sequence of Returns
Mr. Freidman’s point was that averages may hide dangerous possibilities. This is especially true with the stock market. You may be comfortable that the market will deliver its historical average return over the long term, but you can never know when you will be receiving the varying positive and negative returns that comprise the average. The order in which you receive these returns can make a big difference.
For instance, a hypothetical market decline of 30% is not to be unexpected. However, would you rather experience this decline when you have relatively small retirement savings or at the moment you are ready to retire – when your savings may never be more valuable? Without a doubt, the former scenario is preferable, but the timing of that large potential decline is out of your control.
Timing, Timing, Timing
The sequence-of-returns risk is especially problematic while you are in retirement. Down years, in combination with portfolio withdrawals taken to provide retirement income, have the potential to seriously damage the ability of your savings to recover sufficiently, even as the markets fully rebound.
The sequence of returns may significantly impact the income available during retirement. Two retirees with identical wealth can have entirely different financial outcomes, depending on the state of the economy when they start retirement, even if the long-term market averages are the same.3
If you are nearing retirement or already in retirement, it’s time to give serious consideration to the “sequence-of-returns risk” and ask questions about how you can better manage your portfolio.
You cannot directly invest in an index. Investing involves risk including the potential loss of principal. No investment strategy can guarantee a profit or protect against loss in periods of declining values. Diversification does not guarantee profit nor is it guaranteed to protect assets. Opinions expressed are subject to change without notice and are not intended as investment advice or to predict future performance. Past performance does not guarantee future results. Consult your financial professional before making any investment decision. Fixed income investments are subject to various risks including changes in interest rates, credit quality, inflation risk, market valuations, prepayments, corporate events, tax ramifications and other factors. Drake & Associates does not offer tax or legal advice.