What Is Sequence of Returns Risk?

Buy low, sell high.  

That’s probably one of the most common pieces of investing advice out there, and for good reason: It quickly and simply explains how investors make money. If you buy an asset—whether a stock, bond, commodity or anything else—and it increases in value before you sell it, you will have earned a profit. 

Unfortunately, that may not always be possible. Since 1950, the S&P 500 has had an average annualized increase of 11.4 percent each year. But along the way, it has experienced a correction of at least 10 percent roughly every three years.¹ The growth doesn’t happen in a straight line. 

That raises the possibility that you may be forced to sell an asset at a loss if you need access to your money—particularly once you’re living off your savings in retirement. That possibility is known as the “sequence of returns risk,” which is an important concept for investors to understand. 

Below, we take a closer look at what, exactly, sequence of returns risk is. And while you can’t eliminate the risk completely, we offer some advice you can use to mitigate it. 

What is sequence of returns risk? 

Sequence of returns risk refers to the fact that the order, or sequence, of your portfolio’s returns over time, when paired with withdrawals, can have a significant impact on the portfolio’s longevity and ability to replenish itself. It’s also called “sequence risk,” and it’s of special concern for people who are about to retire and other individuals who rely on their investments for income. 

Why does sequence of returns matter? 

If the value of your investments grew at a consistent pace, you’d be able to withdraw your money at any time without worry. But that’s the problem with investments: while investing tends to be one of the best ways to grow your money over time, the growth doesn’t happen in a straight line. A few poorly timed bad years could be the difference between making your savings last or running out of money. 

Consider the following two retirees. Both retired with a portfolio worth $1 million, both took the same $60,000 withdrawals at the end of each year, and both enjoyed an average annual return of 6 percent during the first five years of their retirement. The only difference is the sequence of their returns. 

Despite earning the same average return over five years and withdrawing the same amount of money, Investor A ended the period with $83,288 more than Investor B—purely due to the sequence of their investment returns. Over a 20- to-30-year retirement, the sequence of your returns can be the difference between the ability to make your savings last or running out of money in retirement. 

How to mitigate sequence of returns risk 

When you’re retired, you don’t want to be waking up each morning worried about the stock market. While you can’t eliminate sequence of returns risk entirely, there are steps that you can take to mitigate some of the risk and set yourself up to weather down markets without selling your investments at a loss. That’s where a well-constructed financial plan from Northwestern Mutual can help. 

Use a range of financial options in your retirement plan 

Sequence of returns risk is limited to investments that can lose value just before you need them. Market-based investments are an important component of a retirement plan, but when you pair them with other financial options, you can minimize the risk of needing to sell investments when they have lost value. 

The 60/40 portfolio 

One of the most basic ways to minimize sequence of returns risk is to allocate your portfolio to stocks and bonds. A common allocation for retirees is 60 percent stocks and 40 percent bonds. Because these two asset classes typically move inverse of each other (if stocks fall, bonds tend to rise), this diversification can help to minimize the sequence of returns risk. 

However, it is possible for the value of stocks and bonds to fall at the same time. This happened in 2022 (and several other times over the past century). Further diversifying your investments (commodities performed quite well in 2022) can help. But having an even more comprehensive financial plan that includes strategies beyond your investments is also important. 

A cash buffer 

While everyone’s situation is unique, it’s generally a good idea to have access to a buffer of cash, cash equivalents and/or short-term, high-quality bonds in retirement. 

Why? During a down market, you can tap this cash buffer to cover your living expenses instead of selling your assets at a loss—again, giving your portfolio time to shrug off some of its losses. 

Guaranteed income 

Social Security is the base of nearly all retirement income plans. That’s because it’s income that’s designed to pay you regularly, no matter what’s happening in the markets and no matter how long you live. And while there are some questions about the future of the program, even if lawmakers don’t fix the program, it’s expected to be able to pay out 77 percent of benefits for decades to come. 

Another way to generate guaranteed income in retirement is to use a portion of your retirement savings to buy an income annuity. After an upfront payment, income annuities are designed to pay you guaranteed income for the rest of your life. Again, this is money that’s unaffected by swings in the market and, therefore, can help to shield you from sequence of returns risk. 

It can be a good idea to use a combination of Social Security and an annuity to generate enough income to cover most or all of your essential expenses. This can allow you to be more aggressive with your investments in retirement, as you won’t have to worry about withdrawing from them at a loss to cover living expenses. 

Permanent life insurance  

This is one of the most overlooked retirement planning tools. A permanent life insurance policy will provide a death benefit someday, allowing you to leave money behind for your spouse or your heirs. But its cash value—which is typically uncorrelated with the markets—can be yet another tool to help you weather down markets and minimize sequence of returns risk. 

Building a retirement plan that gets you through good times—and bad 

At Northwestern Mutual, we believe that good financial planning goes beyond your investments. By using a range of financial options that reinforce each other, like investments, annuities and insurance, we build plans to prepare you for any economic season. In fact, a study by EY found the right combination of the three can lead to better outcomes in retirement. Sequence of returns risk is one of the key reasons this broader financial strategy tends to outperform investments-only approaches.  

Our advisors will get to know you and your goals to help you build a financial plan that uses investments, annuities, life insurance and other options to enable you reach your goals without having to spend your retirement worried about things like sequence of returns risk. 

Please remember that all investments carry some level of risk, including loss of principal invested. No investment strategy can guarantee a profit or protect against a loss. 

The primary purpose of permanent life insurance is to provide a death benefit. Using permanent life insurance accumulated value to supplement retirement income will reduce the death benefit and may affect other aspects of the policy. 

¹ Morningstar Direct. Data through 1950 – 7/31/2023.