It’s More than a Paper Loss: Understanding Sequence of Return Risk

When the market experiences a downturn, it’s often said that losses are just “on paper” until you sell your investments. However, this isn’t really the case when you are relying on those investments for income. If you’re in retirement or need to draw money from your portfolio, a market drop can turn those “paper losses” into real financial pain.

The hidden danger: Sequence of return risk

One of the biggest risks you face when withdrawing money from an investment portfolio during a downturn is something called “sequence of return risk.” Simply put, this is the risk that the order and timing of your investment returns are unfavorable. If the market drops significantly early in your retirement while you are withdrawing money, you could deplete your savings much faster than if the market had remained stable or grown.

To help you understand why this is the case, imagine you have a jar of cookies (your retirement savings), and you take one cookie out every day (your withdrawals). If someone comes along and takes a big handful of cookies out of your jar (a market drop), you’ll run out of cookies much faster than you planned, especially if it happens early on in your retirement.

The reality of market drops

It’s easy to get complacent during the good times, but history has shown that bull markets never last forever. Remember, for example, the market drops that took place in 2008, when the S&P 500 fell nearly 40%. Many retirees saw their portfolios plummet. For those needing to withdraw funds, the impact was devastating.

A less severe but still significant drop happened in 2001-2002, when the market fell by around 20% over two years. Many individuals who were drawing down their portfolios ran out of money much sooner than they anticipated.

A look at the numbers

Let’s say your retirement plan is to withdraw 4% of your investment portfolio each year to cover your living expenses. If you have a $2 million portfolio, this means you are withdrawing $80,000 each year.

But what happens if the market drops? If the market plunges 40% like it did in 2008, your portfolio will now be worth just $1.2 million. At this point you’ll be faced with an uncomfortable choice. You could continue to withdraw $80,000 a year – which now represents 6.7% of your portfolio, not just 4% – and risk depleting your savings too soon. Or you could stick with your 4% withdrawal rate, and find a way to make do with $48,000 per year instead of the $80,000 per year that you were counting on.

True diversification means more than just stocks and bonds

Traditional advice has long recommended a diversified portfolio of stocks and bonds, often with a 60/40 split. As a financial advisor specializing in helping women to financially thrive in retirement, I take a different approach.

I believe that true diversification means having parts of your portfolio that are insulated from market declines, geopolitical events like oil embargos, or natural disasters. This includes alternative and buffer investments, including those that are guaranteed and protected in order to provide a safety net when the market turns against you.

Conclusion

When the market drops, especially during critical times like retirement, the consequences can be far more severe than a temporary dip in your portfolio’s value. Understanding sequence of return risk and the importance of true diversification can help protect you from turning a “paper loss” into a financial crisis. Diversifying beyond just stocks and bonds, and including guaranteed, protected investments, can be key to maintaining financial stability in the face of market turmoil.

Want to learn more? As a financial advisor with extensive education in the area of retirement planning, I’m here for you.