Sequence of Return Risk vs Volatility Risk: Understanding the Greater Threat to Retirement


When planning for retirement, many investors focus on market volatility as a key concern. However, a less obvious but equally important concept is sequence of return risk. While both risks impact your retirement portfolio, sequence of return risk is often more significant during retirement. This post explores the difference between the two risks and how each affects your financial future.

Volatility Risk

Volatility risk refers to the ups and downs of the market over time. It’s the uncertainty of returns due to fluctuating asset prices. While volatility is a natural part of investing, its impact is generally less concerning during the accumulation phase of your life, when you're actively contributing to your retirement accounts.

For example, a market dip during your working years might even benefit you, as it allows you to buy more shares at lower prices through dollar-cost averaging. Over the long term, markets have historically recovered, and volatility evens out.

Sequence of Return Risk

Sequence of return risk, on the other hand, refers to the timing of market returns. It specifically becomes a threat during the withdrawal phase of retirement. Unlike volatility, which can smooth out over decades, the order of returns matters significantly when you're drawing down your portfolio.

A string of poor returns early in retirement—combined with withdrawals—can deplete your portfolio faster than expected, leaving less capital to recover when markets rebound. This creates a compounding effect that’s difficult to reverse.

How Sequence of Return Risk Impacts Retirement

Consider two retirees with identical portfolios earning the same average return over 20 years. If one experiences negative returns in the early years, their portfolio may run out of money far sooner, even if the long-term average return matches the other's. Why? Because withdrawals during market downturns force you to sell assets at a loss, locking in those losses.

Which Risk Affects Retirement More?

For retirees, sequence of return risk is more critical than volatility risk. Here’s why:

  1. Timing Matters in Retirement: When you're withdrawing funds, losses early on can have a disproportionate effect on your portfolio's longevity.
  2. Volatility is Manageable in Accumulation: Younger investors have time to ride out market fluctuations and recover from downturns.
  3. Sequence Risk is Permanent: Once you’ve withdrawn funds during a downturn, those dollars are no longer available to benefit from a market recovery.

Using Small-Cap Value to Mitigate Sequence of Return Risk

One effective strategy to combat sequence of return risk is incorporating small-cap value (SCV) stocks into your portfolio. SCV stocks have historically delivered higher long-term returns compared to broader indexes like the S&P 500, helping to offset the impact of early retirement market downturns.

As highlighted in the blog post "Why Small-Cap Value (SCV) Outshines the S&P 500", "small-cap value stocks consistently outperform larger cap counterparts over long time horizons due to their higher risk premiums and greater growth potential." Adding SCV to your retirement portfolio can provide a higher expected return while maintaining diversification, which may help you recover faster from early losses.

By strategically allocating a portion of your assets to SCV, you can balance growth potential and risk. Combine this with other tools like a cash buffer and a flexible withdrawal strategy, and you’re better equipped to navigate sequence of return risk during retirement.

Conclusion

While both sequence of return risk and volatility risk affect your retirement planning, the former is far more dangerous during retirement. A solid financial plan that accounts for sequence risk can protect your portfolio and ensure a comfortable retirement. Understanding the difference and preparing accordingly can make all the difference in your financial future.

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