Most of us spend our working years dreaming (and planning) for retirement daily. We know that to free ourselves from bondage, we must have a solid retirement plan in place.
Conventional wisdom has us invest 10% into our 401Ks and Roth IRAs over 35-45 years. Hopefully, we retire with $1-2 million, but that is rare.
In a perfect world, as we retire, the stock market will be at all-time highs, and we can sell a few shares of our index funds to generate our required income. But the world is imperfect.
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What is the sequence of returns risk? Put simply, sequence of returns risk (SRR) is when you must sell more shares during a downturn to generate the required income.
Because you sell more shares early in retirement, your recovery prospects are much more limited than if you had more shares. Let’s explore a scenario.
Let’s say you retire on January 1, 2024. You have 5000 shares of the Total Stock Market Index Fund (VTI). The shares are worth $200 each, giving you $1 million. That first year, you sell 200 shares to generate $40,000. Easy day.
Now, the market will take a downturn during 2024. On Jan 1, 2025, you need to generate $40,000 again. However, your VTI shares are now worth $120. You must sell 334 shares to generate the same $40,000.
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SRR kicks in because you are now selling more shares needed for recovery. The power of compounding is working its magic AGAINST you.
How to prevent SRR from creeping into your retirement. I want to explore some ways to prevent SRR from destroying your retirement.
Although selling a few more shares may seem trivial, it can cause massive wealth destruction over 20-30 years of retirement.
Should you use your emergency fund? If you have a nice emergency fund of 12-24 months, should you use it during a downturn instead of selling shares?
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That’s a tricky question. We never know how long a downturn will last nor how fast recovery will occur. We are blind to the future.
The last thing you want is to burn through your cash reserves. You could supplement $10,000 of your required $40,000 from your emergency fund.
Bonds are your friend, sometimes. Generally, during a market downturn, the value of bonds rises. They are usually the ying to the stock markets yang.
However, recently bonds have suffered just as much as stocks because of interest rate manipulation.
Still, selling bonds is better than selling stocks because you never expected capital appreciation on bonds.
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If you created a Treasury Bond ladder, you might have some bonds that outperformed during that particular recession.
For example, if you have 30-Year bonds at 5%, they will do well in a 2% interest rate environment.
It would be even better to have enough income from bonds to supplement $20,000 to $30,000 of your living expenses. Living on bond income would be ideal.
Get a job or roommate. This is simple, make money another way. Get a part-time job, rent your car, or get a roommate or two. You must supplement your income by using practical methods.
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Never sell shares. I am not a big fan of 401Ks and index funds for a few reasons, mainly selling shares and SRR.
The other reason is that people use these products as savings accounts—meaning they never learn to invest truly.
People call in a financial advisor to handle their nest egg when they retire. SRR occurs, but the advisor may not know how to counteract it or protect your future.
My philosophy is never to sell shares. I do this by generating my income from dividends. Dividend investing allows me to keep the golden goose that lays the golden eggs.
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A shift in mindset. Instead of focusing on growing your nest egg to $1 million or $2 million, focus on increasing your dividend income to $40,000/year.
That way, when you retire, you already know you are good to go—there are no surprises. Sure, some companies can cut or eliminate their dividends during a downturn.
However, most companies will continue their dividends; others will raise their payouts and even execute special dividends.
Very rarely will your dividend income decrease year-over-year. In fact, I have been dividend investing for four years across two recessions, and my dividend income keeps growing exponentially.
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I am currently on track to earn roughly $20,000 in dividends in 2023. I am 42 and have another 20+ years to hit full retirement age.
Not only can I continue to grow my dividend portfolio, but I can increase my emergency fund and bond portfolio.
I will retire with a fully funded portfolio that protects me from selling shares, market downturns, and any other funny business.
Learning the ropes. However, you must take the time to learn about money and your retirement future.
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People use 401Ks because they are simple to grow during their working years. I understand this fully. But nothing comes for free.
Do you genuinely want your financial advisor to handle your $1 million portfolio? At the very least, you must understand what’s at risk if you don’t learn the ropes.
If you can live on $40,000/year during retirement (plus social security), create a plan to earn this much outside the stock market.
Renting a room for $1,000 per month can generate $12,000/year, and using your yard as a dog park may generate $6,000/year. That’s already $18,000/year.
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Conclusion. Ultimately, the sequence of return risk affects those who don’t want to overcome their situation.
I am not making it sound simple to avoid selling during a market downturn; however, selling is always a choice.
That means you can avoid selling by putting financial, physical, and educational protections in place to generate income (and stop the bleeding).
It’s never a good idea to rely on only one source of income, even in your working years. As much as I love income investing, I still have a book business and real estate to help me through life.
Your retirement is only as good as you build it. Saving money in a 401K is only part of the picture, with the other half understanding how to generate income from various sources, including dividends. Good Luck!
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