Sequence risk of returns also known as Sequence Risk can be one of the biggest risks in Early retirement. It is primarily the order in which the investment returns are received. The risk of market crashing right at the beginning of your retirement can have a great impact on how long your retirement assets will last.
Many of our readers and we ourselves have always worried about such an event- what if things go wrong at the end of our investment journey or right at the start of the early retirement. We had no idea that our worry also has a financial term – Sequence Risk.
Good thing is that now our and your worry has a name. We may find a solution for it as well.
What is Sequence Risk of Returns?
Most Early retirees have a significant part of their retirement portfolio invested in Equity Markets. Reason being that over a period of time equities have given inflation-beating returns. But these return assumptions are averaged over a period of time. This you may already know and we have also written about it in '12% return from stock market every year?'. Returns from Equity markets are not Fixed returns like FD’s. In Equities one year you may get 25% returns (like 2015) and another year get negative returns of -38% (2009). The problem is we have no way of knowing which year will be up or which year will be down. And that is the biggest challenge. No one knows in which sequence market returns will occur. Also called a Sequence risk of returns or Sequence Risk.
Sequence Risk reduces your Retirement Portfolio
Sequence risk is the biggest risk for Early Retiree, not because the market will crash, as eventually, markets do recover. But because of the fact that you will face your worst returns at the beginning of your portfolio. Withdrawing money during a significant down market early in your retirement has the tendency to create a situation where there is not enough remaining in the portfolio to participate in the recovery process and put the retiree back in a financially secure position.
Sequence Risk’s Impact Explained with an Example
Let’s go further with an example: Picking up a thread from our blog post Safe Withdrawal Rate- How long will your money last in retirement where we simulated an early retirement portfolio of 50/50 Equity and Debt and tested it under different assumptions. If you have not read that blog, do read it before continuing with this post.
In this post, we will take forward one of those assumptions. Put it through some extreme market volatility to understand how bad can things go.
However, Things would be very different for someone if the starting year market gave negative returns. So, for this experiment we replaced 1997 returns with below negative returns:
These results are disturbing, no sugar coating there. Imagine you are all set to retire early in XYZ year and the same year market dips and reduces your asset value. Forcing you to either cut your expenses or postpone your retirement date till markets recover.
This is a possibility every Early retiree should be prepared for mentally. No one can control or predict the sequence in which market returns will happen. And that is the biggest curveball markets can through at early retiree’s plan.
In the next blog post, we will explore what options do an Early retiree have when something like this happens. Ultimately being prepared for Early retirement is the idea behind this blog.
If you have already thought about Sequence Risk and have some tips under your sleeves. Feel free to share them with us in comments. We would love to hear from you.
Lastly, Shout-out to any Tax experts reading this blog and is interested to help us. We want help with working out the tax implication on a few dummy ER portfolios. Please get in touch with us. We would really appreciate your help.
As you guys know after sequence Risk, Tax is the biggest unresolved piece we have to work out.
We have already written about How much money I need to Retire Early In India and Safe Withdrawal Rate- How long will your money last in retirement. If you have not read them, we highly recommend you to do read them.
First Published: IST