Sequence risk refers to the risk incurred by a financial portfolio when that it sustains periodic withdrawals by the owner of the portfolio. This generally occurs with people who are retired and need cash flow from their portfolios as a means of covering living expenses when they can no longer work. If a portfolio suffers a series of negative events at the time when withdrawals are necessary, it can be particularly damaging and may require smaller withdrawals in the future. To manage sequence risk, people must try to balance out the rate at which they make withdrawals with the amount of risk surrounding the portfolio as a whole.
Many people set up their investment portfolios with the intent of providing income after they have reached an age which no longer allows them to work. In this way, they can still receive cash flows to cover their costs of living. Ideally, these people would receive a steady flow of cash at regular intervals, but this process can be interrupted by periodic market upheaval. For this reason, investors must consider sequence risk to avoid a potential financial calamity in their retirement years.
As an example of how sequence risk works, imagine two different retirees. Both have the exact same amount of money in their portfolios at the time of their retirement, but they retire at different times. The first person begins making withdrawals at a time when the stock market begins a long upward surge. By contrast, the second person's withdrawals for retirement begin right as the market begins to plunge. Even though the two investors entered retirement on even footing, the first person is in much better financial shape than the second.
Although the rate of returns for portfolios usually balance out over a period of time, periods of market negativity can be harmful if they occur at the time withdrawals need to be made. Investors need to be wary of this phenomenon as they consider sequence risk. Those who ignore it and plan to take out the same amount of money with each withdrawal may find themselves suddenly running out of money.
While it may be impossible to completely eliminate sequence risk, investors can take steps to mitigate its damage. By studying the market and knowing when it may be entering a period of volatility, investors can tailor their withdrawals to make sure they are not too exposed. In addition, investors might wish to base their withdrawals on a certain percentage of their overall portfolios instead of locking into a set amount each time. This can remedy the risks of a leaving a portfolio short on funds when economic turbulence hits.