If you are planning investment for your retirement, you should be aware of the sequence of return risk. Do you know what it is? In the early years of investing or even after investing for several years towards building a retirement corpus or as soon as you get closer to retirement day, the return on your investment portfolio crashes all of a sudden thus resulting in your retirement corpus becoming insufficient to meet your retirement goals. The risk of falling short of your retirement corpus due to a sudden crash in the return on investment is called the sequence of return risk. Let’s understand why the sequence of return risk happens and the steps you can take to avoid it.

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When You May Get Exposed To The Sequence Of Return Risk?

Lack of diversification in the investment portfolio is often one of the important reasons for causing the sequence of return risk. At the start of their career, investors who put all their money into a single asset class is at a higher risk of incurring negative returns in their portfolio compared to investors who have diversified their investments into different asset classes. Similarly, investors who stay invested in risky assets despite getting closer to their retirement have a high chance of getting a negative return at the last moment. Some investors choose the wrong sequence of investment, i.e., they invest in low-risk debt instruments at the starting stage of their career and take a high risk by investing in equity assets when they get closer to retirement, thus they fail to achieve the target retirement corpus.

Due to the sequence of return risk retiree ends up with a lower-than-required retirement corpus to meet their financial needs for their remaining life.

How You Can Avoid The Sequence Of Return Risk?

Investors can easily avoid the sequence of return risk by diversifying their investment portfolio to different asset classes. If one of the assets gives you a negative return, the asset classes will bring you closer to your target retirement corpus. If the target corpus is achieved before the planned tenure, then the entire corpus should be parked to low-risk investments to avoid a loss at a later stage.

The portfolio should be rebalanced from time to time in sync with the planned allocation to debt and equity instruments. For example, if the return on equity increases such that the allocation ratio in debt and equity asset becomes 80:20, exceeding the planned allocation ratio of 60:40. In this case, the fund allocation from the equity portion should be shifted to debt such that the ratio again comes down to 60:40.

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You can use the bucket strategy to lower the chance of sequence risk. Under bucket strategy, you need to separate your cash liquidity need for meeting your retirement expenses in the 5 years, from your investments meant for meeting your financial needs after 5 years.

Despite all efforts, if you still get exposed to sequence of return risk, you can reduce its impact by withdrawing fund from your retirement corpus through systematic withdrawal plan (SWP) instead of withdrawing a large sum at once. Starting a part-time job or a small business to increase the income stream after retirement can also help when you become a victim of a sequence of return risk.

The author is an independent financial journalist.