The Importance of Sequence of Returns in the Stock Market

November 05, 2024

By: Pedro Regalado

The Importance of Sequence of Returns in the Stock Market


When it comes to investing in the stock market, many people focus on achieving strong average returns over time. However, there’s a less talked about factor that can have a significant impact on your portfolio: the sequence of returns. Understanding how the order of returns affects your investments- especially during retirement or withdrawal phases– can be crucial to ensuring your financial security.

Sequence of Return Risk

What is Sequence of Returns?

The Sequence of returns refers to the order in which positive and negative returns occur in your investment portfolio. While the average return over a certain period is important, the timing of these returns can greatly affect the longevity of your portfolio. In other words, it’s not just how much your investments earn, but when they earn that can make or break your retirement savings.

For example, two investors may have the same average return per year over a decade, but if one experiences negative returns in the early years, the outcomes can be vastly different. This is particularly critical when you’re withdrawing money from your investments to live on, such as during retirement.

 

Why Sequence of Returns Matters

  1. Impact During Withdrawals: One of the biggest reasons the sequence of returns matters is because of the effect it has during the withdrawal phase of your investment plan. When you’re taking out money regularly, early losses can severely reduce your portfolio, and it may never recover – even if the market performs well later on. This is called sequence risk, and it can lead to depleting your savings faster than expected.
  2. Volatility and Market Timing: The stock market is inherently volatile, meaning returns fluctuate year by year. If you retire or start drawing down form your portfolio in a year when the market is down, it could dramatically alter your future returns. This is because you’re selling assets at a loss, which diminishes the base of your investments. When the market rebounds, there are fewer assets left to grow.
  3. Accumulation vs Distribution phases: During the accumulating phase-when you’re still adding to your investments-the sequence of returns doesn’t matter as much because you’re not drawing down. However, once you start taking withdrawals, the timing of negative returns becomes more important. This makes retirement planning more complex than just looking at long-term average returns.

 

Strategies to Manage Sequence of Returns Risk

  1. Diversify your Portfolio: Effective risk management starts with robust diversification. Since no one can predict market movements, being overly exposed or underexposed to any particular sector can significantly affect a portfolio’s overall performance. We invest evenly across market sectors to mitigate this risk.
  2. Minimize Losses: sound risk strategy seeks to prevent investment losses from escalating into significant damage. To achieve this, we have implemented a stop-loss plan. If our proprietary index declines by a set amount, the stop-loss is activated, automatically selling equities within the portfolio.
  1. Remove Emotion from the Equation: A disciplined risk approach removes human emotion from the investment process. By using a mechanical investment management method, we uphold our discipline and respond to changing markets only when our established rules require it.
  2. Bucket Strategy: Some investors use a bucket strategy, where they divide their investments into different “buckets” based on when they plan to use the money. For example, money needed in the next few years might be kept in low-risk assets like bonds or cash, while money that won’t be touched for 110+ years can remain in stocks. This can help protect against withdrawing during market downturns.
  3. Adjust Withdrawal Rates: Another way to safeguard your investments is to be flexible with your withdrawal rate. In years when the market performs poorly, consider reducing your withdrawals to preserve your capital. Conversely, when the market is up, you can afford to take out a bit more.

 

The Bottom Line

The sequence of returns is an often overlooked but crucial factor in retirement planning and long-term investing. While the average returns on investments are important, the timing of those returns—especially during the withdrawal phase—can significantly impact how long a portfolio lasts. By understanding and managing the risks associated with the sequence of returns, you can create a more resilient financial plan.

For advisors working with clients who are planning for retirement or are already in the withdrawal phase, it’s vital to help them develop a strategy that addresses this critical risk. By emphasizing careful planning and diversification, you can assist them in mitigating the negative impacts of the sequence of returns, leading to a more secure financial future.

When discussing this risk with clients, clarify that the sequence of returns refers to the potential effects of market fluctuations on their withdrawals. Encourage them to focus on strategies that provide stability during downturns, such as the ones we discussed in this blog. This approach can help ensure they don’t deplete their savings prematurely, allowing them to enjoy their retirement with greater peace of mind.

 

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FOR ADVISOR USE ONLY. NOT INTENDED FOR CONSUMER SOLICITATION PURPOSES.

Beacon Capital Management, Inc. is an investment adviser registered with the Securities and Exchange Commission. Additional information about Beacon Capital Management is also available on the SEC’s website at www.adviserinfo.sec.gov under CRD number 120641. Beacon Capital Management only transacts business in states where it is properly registered or excluded or exempted from registration requirements.

Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments or investment strategies.

Sammons Financial® is the marketing name for Sammons® Financial Group, Inc.’s member companies, including Beacon Capital ManagementSM.

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