What is Sequence of Returns Risk?
As an investor, you've likely heard of the phrase "sequence of returns," but do you truly understand its importance? This fundamental concept can significantly impact your investment journey and ultimately determine whether you achieve your financial goals. Let's delve into the world of sequence of returns and discover why it matters.
What is a Portfolio's “Sequence of Returns”?
Sequence of returns refers to the order in which investment returns occur over time. It can vary greatly due to the volatile nature of financial markets, economic conditions, and other external factors. Essentially, it outlines the journey of your portfolio's performance, from the early years of investing to the maturity of your investments.
Why it Matters:
Sequence of returns is crucial because it can profoundly affect the final outcome of your investment portfolio. Two investors with identical average returns over a specific period can achieve vastly different results due to the timing and order of those returns.
The Impact of Sequence of Returns Risk on Withdrawals:
Source: Schwab Center for Financial Research
Consider two scenarios:
- Favorable Sequence of Returns: When positive returns happen early in your investment journey, compounding works in your favor, amplifying your wealth over time. The growth potential of your portfolio increases, allowing you to reach your financial goals more efficiently.
- Unfavorable Sequence of Returns: Conversely, negative returns occurring early in your investment tenure can severely hamper the compounding effect. This can lead to a significant reduction in your portfolio's overall value and may hinder your ability to meet your financial objectives.
This is especially key if you are retired or near retirement:
Failure to manage your sequence of returns can quickly lead to running out of savings when you're in the withdrawal phase of your financial journey.
Source: Schwab Center for Financial Research
How to use this knowledge:
Set More Realistic Expectations:
- Understanding sequence of returns can help you set more realistic expectations about the performance of your portfolio over time.
- It allows you to anticipate potential risks and uncertainties, thus helping you avoid making impulsive investment decisions during periods of market volatility.
Tailor Your Risk Management:
- Knowing the impact of unfavorable sequences can prompt you to adopt a risk management approach in your investment strategy.
- Diversifying your portfolio, balancing asset allocation, and aligning investments with your risk tolerance can all help mitigate the effects of market downturns.
Reframe Long-Term Planning:
- By acknowledging the significance of sequence of returns, you can develop a more robust long-term financial plan.
- This can include adjusting your saving and spending habits, reassessing your retirement goals, and fine-tuning your investment strategy to better navigate market fluctuations.
This free tool can help you plan!
To help you better understand the potential impact of sequence of returns on your investment portfolio, we offer a powerful tool called Portfolio DeepScan®. This free tool employs advanced market simulations to analyze your portfolio's performance under various scenarios, including market crashes and economic downturns.
With a Portfolio DeepScan® you will receive:
Asset Allocation Analysis: Comprehensive asset allocation analysis, offering you a clear breakdown of your portfolio's exposure to different asset classes.
Understanding your asset allocation is vital, as it directly influences your portfolio's risk and return potential.
Loss Quantification: Gain insights into the estimated losses your portfolio may incur during market downturns.
Calculating the potential impact of negative sequences on your portfolio allows you to implement proactive risk management strategies.
Estimated Portfolio Returns: Discover your portfolio's target return and assess to help assess sequence of returns risk.
By comprehending the potential consequences of different return sequences, you can make more informed decisions and take actions to optimize your investment outcomes.
This article is provided by McAdam LLC dba RetireUS for informational purposes only. Investing involves the risk of loss and investors should be prepared to bear potential losses. Past performance may not be indicative of future results and may have been impacted by events and economic conditions that will not prevail in the future. No portion of this article is to be construed as a solicitation to buy or sell a security or the provision of personalized investment, tax, or legal advice. Certain information contained in this report is derived from sources that McAdam believes to be reliable; however, the Firm does not guarantee the accuracy or timeliness of such information and assumes no liability for any resulting damages. This article is the sole opinion of this individual and is not indicative of the firm’s belief.
