What is Sequence Risk?
A common assumption when planning for retirement is that your portfolio will grow at an average rate each year. This helps simplify projections when determining if your nest egg is sufficient enough to last through your retirement.
However, in the real world, future investment returns are rather unpredictable from year to year. This means a string of poor investment returns is not uncommon and can potentially cause your returns to be lower than expected. This is known as sequence risk.
The Potential Impact Sequence Risk Can Have on Your Retirement
If a series of negative returns occurs during the period leading up to or immediately after your retirement, there could be a major impact on your retirement nest egg. This is because sequence risk amplifies investment volatility since you are selling shares at a depressed value to fund your retirement expenses.
As a result, there could potentially be a permanent impairment in the amount of retirement income you could generate from your portfolio if there was a dramatic market decline early in your retirement.
How to Potentially Mitigate Sequence Risk
Unfortunately, there is little you can do to control the economic or stock market conditions surrounding your retirement. However, you are able to take steps to attempt to insulate your portfolio from the volatility of the market.
This means you could carve out portions of your nest egg and place it in investments that attempt to mitigate risk to fund your upcoming years of retirement spending. This way you do not have to sell other investments that may have decreased in value but instead are using funds that were already set aside for that purpose.
In addition, it could make sense to reduce your discretionary spending during a period of poor returns. This could include, postponing a trip, delaying major purchases, or cutting your portfolio withdraws by a certain percentage.
During this time, you could also look to tap other sources of liquidity to allow your investment portfolio to recover.
With a retirement that could last 30+ years, it is important to consider the impact that a sequence of negative investment returns early on can have on the longevity of your nest egg. Awareness of this risk allows you to develop a strategy to attempt to mitigate this risk during the years surrounding your retirement.
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