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One of the Most Underappreciated Dangers of Investing

Sequence-of-returns risk matters for both retirees and savers. Here's why.

Susan Dziubinski: Hi, I'm Susan Dziubinski with Morningstar. Sequence-of-return risk can undermine the portfolios of retirees and savers alike. Joining me today to unpack the concept and discuss how investors can mitigate the risk is Amy Arnott. Amy is a portfolio strategist with Morningstar.

Hi, Amy, thanks for joining me today.

Amy Arnott: Hi. Nice to see you in person, after all this time.

Dziubinski: Yes, it is. Now, in a recent column, you called sequence-of-return risk, one of the more underappreciated risks of investing. Let's start at the very beginning. What is sequence-of-return risk?

Arnott: Sequence of return risk basically starts with the order of returns. And it's something that can affect your results, especially if you are buying and selling shares over time. And it's something to keep an eye on, especially in the first 10 years or so after retirement.

Dziubinski: Now, we have gone through periods in the market where we've seen what you've called serious negative sequence of returns. How common is that? How often does that happen?

Arnott: They're pretty rare. If you go back to 1926, there's only four periods when we've had a really serious negative sequence of returns, which would be more than at least two years of consecutive negative returns. And the most recent period was 2000 to 2002, during the tech correction.

Dziubinski: You say that this is a bigger risk, it's more significant for retirees. Walk us through why that it is a much bigger issue for retirees.

Arnott: If you're retired, you're probably taking withdrawals from your portfolio, which reduces the value. But then if the market is down, that reduces the value even more, so it's sort of a double whammy. And it can also hurt your results because there's not as much value left to rebound when the market recovers.

Dziubinski: What are some things that retirees might be able to do to protect their portfolios, protect themselves against this sequence-of-return risk?

Arnott: One of the most important things you can do is make sure you have a balanced portfolio that includes both stocks and bonds, because bonds can usually provide a buffer when the equity market is down. Another thing you can do is follow a bucket strategy, which we've talked about a lot over the years. And that would involve taking at least one or two years of planned withdrawals and keeping them in cash. And that way, you're kind of insulated from sequence-of-returns risk.

Dziubinski: Let's talk a little bit now about those who are still savers and are accumulating assets. You say that sequence-of-return risk is perhaps less of a threat for them. But it still is a risk. How does it manifest itself for savers?

Arnott: If you're just starting out, you really don't have to worry too much about sequence-of-returns risk, because even if you have, let's say, two or three years of negative returns and your portfolio's very heavily focused on equities, you have enough time that more than likely your portfolio is going to recover. I would say it's really when you start getting into your 40s or 50s when it's something that you need to start thinking about and probably start shifting at least a portion of your portfolio into fixed-income securities.

Dziubinski: Is that the best approach then for somebody who, say, is in their 40s or 50s and wants to protect against that sequence-of-return risk, is to start putting a little bit of money aside into bonds?

Arnott: I think it's a sensible approach, and it can help insulate you from any kind of negative sequence.

Dziubinski: Well, Amy, thank you for your time today helping unpack this concept and making us a little bit more aware of this risk that a lot of us don't necessarily think about. We appreciate it.

Arnott: Thanks. Great to be here.

Dziubinski: I'm Susan Dziubinski with Morningstar. Thanks for tuning in.