Sequence of Returns Risk, or, If the Bottom Drops When I Can Least Afford It

Retirements were put on hold back in 2007 when the markets tanked as the housing bubble burst. Worse off were those retirees in the first years of post-employment; their investments were in use but they had little time to continue maturing. What could these investors have done to avoid what had happened to them?

This hazard is called the “sequence of returns risk,” where the order in which investments record annual gains and losses can have a massive effect on accumulated wealth. There exist a couple of practices we can take that can mitigate this risk. Those near-retirees who made the news back then were all but certainly not exercising either of them.

Our choices help shape our financial future. Deciding them can feel like looking into the void for some. For many workers, it’s a source of anxiety, even fear. They often delay making decisions or acting upon them, which are costly mistakes. If thinking through the particulars of asset allocation or if retirement investing as a whole are off-putting, the best move is to make an appointment with a professional investment advisor.

Now for those two practices.

First, adjusting risk asset allocation (stocks) according to age. Younger investors, particularly professionals with a strong likelihood of decades of increasing income ahead of them, can shoulder much financial risk. That means an all-stock allocation at least until the mid-forties because there’s likely more income ahead of them. Older investors have fewer years to recover from market tumbles, so they should be more conservative in their approach.

Some investors accomplish this progression from higher to lower risk by rebalancing their portfolio annually using the one-hundred-minus-my-age rule of thumb, or 110-age, or for the more aggressive, 130-age. That means a 60% stock allocation at age 40 for a cautious investor or a 90% allocation for the more aggressive.

Alternatively, target-date retirement funds are tailor-made for this practice. By picking a fund targeted for a date closest to a prospective retirement date and depositing to it regularly and automatically, an investor can be assured of proper risk allocation according to age. By the time a worker is approaching her prospective retirement date, most of the assets will be bonds and cash-like. These funds are a terrific choice for workers who don’t want to dive into the details of investing.

The particular rule or fund in use is less important than the application itself—the stock allocation shrinks as the investor approaches retirement. Sudden declines in the stock market become less consequential, even as an age when the consequences would be more dire approaches.

Those investors who had to postpone retirement back in 2007 were too deeply into stocks with just a year or two of employment left, often with little or no bond or cash cushion. A bond cushion buffers a loss in stocks because bonds rarely decline much when stocks are falling. They usually appreciate as stock investors bail out and head for safety.

A cash cushion allows a retired investor to ignore stock losses nearly altogether since she can always draw on that cushion for income rather than stock holdings.

Therein lies the second and, perhaps, more critical practice of having a cash-like holding in the portfolio once I’m within five years of leaving full-time employment.

Investment advice is replete with examples of big-name investors who maintain substantial cash reserves. Warren Buffet is one; I’ve read accounts of his holding cash above 30% of Berkshire Hathaway’s assets. Berkshire’s assets aren’t a retirement portfolio, but the principle is the same. Whether the money is in reserve for investment opportunities after a market tumble or is held for income, having it on-hand means never being caught short.

As an example, I rebalanced my retirement portfolio to a much lower stock allocation when market indices, such as the S&P 500, recently came back to near-even for 2020. In the process, I moved a minor portion of the assets into a short-term US Treasury bond fund, which, due to its duration, acts much like a money market fund. By my post-retirement calculations, it now holds about two years-worth of needed investment income. I’ll carry that allocation into retirement in a few years.

Should the market stall and decline in my last year of work, I can keep my exit date. Should the market decline in the following few years, it’s safe to continue drawing from my portfolio. I have only to switch the source from stocks to cash-like funds in either case.

There are significant inherent risks to relying on the public markets rather than a pension for retirement income. Those risks can be effectively managed with a bit of reading and careful thought, or a relationship with an investment advisor. The resulting peace of mind is also a valuable asset.