A 50% decline is bigger than a 50% gain if it happens first. Let’s take a quick look at Sequence of Returns risk.
Your investment portfolio is represented by a pie, raspberry if you like.
Pretend that you have worked hard for 15 years, saving 54% of your income and are ready to embrace your financial independence. The day after you step into your new life, the market crashes 50%, wiping out half of your portfolio’s value. Think of your portfolio looking like half a pie now. Ouch.
In our simple example, it is a volatile market. The very next day, the market soars 50%!
You’re back to where you started, right?
Nope.
You’re only at 75% of your original balance. A 50% gain after a 50% loss is only a 25% gain on the original amount.
If you needed to buy groceries or pay your mortgage (or make any withdrawal from your portfolio) while the market was down, you have even less left.
This simple example illustrates sequence of return risk where a decline in the portfolio happens shortly after someone starts to draw from it (e.g., in early retirement or FI years).
How to mitigate sequence of return risk:
- Manage your asset allocation. Keep some bonds, cash, & stocks in your portfolio, especially if you’re planning to draw from it soon. In this way, you won’t have to sell stocks when they’re down in order to eat.
- Continue to generate some income so required portfolio withdrawals can be reduced. If you keep working or pick up some extra work, that income can be used for living expenses instead of selling assets at a loss during an early down turn.
- Start with a bigger pie.
- Eat less pie (reduce expenses during downturns)