DEFINITION of ‘Sequence Risk ‘
Sequence risk, also called sequence-of-returns risk, is the risk of receiving lower or negative returns early in a period when withdrawals are made from an individual’s underlying investments. The order or the sequence of investment returns is a primary concern for retirees who are living off the income and capital of their investments.
BREAKING DOWN ‘Sequence Risk ‘
It is not just long-term average returns that impact your financial wealth, but the timing of those returns. When retirees begin withdrawing money from their investments, the returns during the first few years can have a major impact on their wealth.
Two retirees with identical wealth can have entirely different financial outcomes, depending on when they start retirement – even if the long-term market averages are the same.
For example, a retiree starting out at the bottom of a bear market will see the prices of the holdings in his or her portfolio rise when the market recovers. More crucially, though, that retiree will also see a reduction in the overall return of that portfolio because of how much had to be withdrawn in early retirement when prices were down.
By contrast, someone who retires when stock prices are high – letting him or her take early withdrawals of fewer equities because they are worth more – will likely have a higher overall portfolio return than the bear-market retiree earns. This is because the high-stock-prices retiree has more equities left in that portfolio to earn returns later in retirement.