Mitigating Sequence Risk

Don't throw away years of good planning by overlooking an adverse return sequence.

Marketwatch took a stab at trying to come up with what a suitable allocation to equities might be for someone about to retire or newly retired. I was glad to see that sequence of return risk was included in the discussion. As a quick reminder, a sequence of returns is just that, returns you get over some period of time; up 5% one year, 6% the next, then down 3% and so on. The risk comes when there is an adverse sequence right around the time you plan to retire or otherwise use the money.

Someone who is 62, has hit their number and plans to retire in two years might have to make some serious changes if in the 12 months before they retire, the stock market cuts in half. Serious changes would also be required if a 50% decline came a few months into retirement.

To mitigate that risk, the article suggested keeping about 50% in stocks and then a good amount of cash to cover expected income needs for a couple of years. The idea behind two or three years of anticipated cash needs set aside is that the typical bear market lasts for about two years.

That is certainly valid but there can be several valid ways to address this risk. Other strategies could include a more aggressive cash position with maybe a 30% allocation to equities or a more tactical approach to asset allocation like taking defensive action based on a technical trigger. The advantage of raising really a lot of cash is not worrying at all about the stock market, the downside is doing this in like late 2014 and then watching the stock market go up more than 50% in five years. I obviously have a lot of faith in the more tactical approach (it is what I do for clients) but the downsides include making some sort of error and having to be somewhat engaged in markets, maybe moreso than hoped for (most people aren't that interested in engaging markets on a very regular basis). Another option is investment products that will take defensive action for you. I include one or two of these in client portfolios and believe in them but that's not to say something could never go wrong along the lines of the unforeseen blowup in auction rate preferred securities during the financial crisis.

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