Why It's So Critical to Understand Sequence-of-Returns Risk If You Want Your Nest Egg to Outlast Your Retirement

As an investor, you've probably learned something about how to find companies you believe are poised to make their shareholders money, and you've undoubtedly heard how beneficial it is to continue investing even when the market is shaky. But one term you may not have learned is "sequence-of-returns risk." This refers to the impact that the timing of your withdrawals can have on your portfolio.

And understanding it will be critical if you're going to reach your long-term retirement goals.

Where to invest $1,000 right now? Our analyst team just revealed what they believe are the 10 best stocks to buy right now. Continue »

Image Source: Getty Images.

The most important thing to remember

A significant drop in the value of your portfolio during the early years of retirement can meaningfully impact how long your portfolio will hold up during your golden years.

Let's say, for example, that a bear market hits just after you retire. Stocks are in the tank, and your portfolio is losing value. Now, imagine your financial plan is based on the idea that you'll withdraw 3% from your retirement accounts each year (adjusting upward for inflation over time). If you do that in a rising market, your investments should be gaining enough that the stock sales involved won't take as much of a toll on the value of your portfolio. In fact, you could even end the year with your portfolio worth more than it was at its start, despite your selling shares.

However, in this scenario, share prices are down, which means that you'll need to sell more shares to raise the same amount of cash. And the value of your portfolio was dropping at the same time. The timing of that particular withdrawal not only drains your account faster but also leaves you with fewer assets that can generate growth and returns as the market recovers.

If only you were older

In a nutshell, a hit to your retirement account in the early years will do more damage than it would if you were older and didn't need your nest egg to last for so long. Regardless of your age, it's never fun to watch the value of your portfolio shrink, but it's scarier when you expect you're going to need your nest egg to cover your bills for many years, but you're left with less than you expected to have -- meaning that even when the market gets back to growth, you'll see less real benefit from that growth.

A retirement account is more than a warehouse for the money you'll need in retirement. Ideally, it's a mix of investments that provide both the income you require and a level of growth that continually replenishes a portion of the withdrawals you make. The better job your account does of growing and replenishing, the longer your money will last.

So, what's the answer?

You've probably watched the market rise and fall more times than you care to remember, and know that it's a natural part of the economic cycle. However, if you don't want big drops in the market to have too much of a negative impact on your long-term financial picture, here are some steps you can take.

Hold some less volatile assets you can draw from as needed

Ideally, you'll have a portion of your money held in assets that aren't so exposed to the ups and downs of the stock market -- funds that you can use to cover expenses without selling stocks when they're down. If you have investments in high-quality short-term bonds, short-term bond funds, or any other low-risk liquid investments, take money from those rather than withdrawing funds from your stock-based retirement accounts when it's down.

If you don't have such a reserve, consider building one when the market is back in growth mode and your portfolio is getting healthier. For example, if you don't need every dollar from your required minimum distributions (RMDs), take advantage of the situation by tucking the money you don't need today into a fund for the future.

Scale back on your withdrawals

If you're 73 and taking RMDs, you know that you must withdraw a specific percentage of each tax-advantaged retirement account's value each year. Fail to do so, and you'll owe the IRS a painful penalty. However, bear markets are an excellent time not to take a penny more than you have to. Whether you're taking RMDs or not, bear markets are also a good time to forgo inflation adjustments, postpone large expenses, and reduce discretionary spending. The less you take from your account during such times, the better you position yourself to benefit from the market's future growth.

Avoid panic selling

According to The Hartford Fund, about 42% of the S&P 500 Index's strongest days occurred during the late stages of bear markets as Wall Street began to turn around. But it's not as though there's a flashing red light that announces when the market is transitioning from a bear to a bull market. The signs can be subtle and next to impossible to predict. Remaining fully invested during downturns means you won't miss out on the most lucrative parts of the recoveries that generally follow them.

Consult a financial advisor

No matter how often you've experienced turbulent markets, they can be nerve-wracking. If you want a set of well-trained eyes to help you analyze your financial situation, consider consulting a financial advisor. Professional guidance may be precisely what you need to make informed decisions and optimize your retirement plan.

So much in life is about timing, from where you are in line when a winning lottery ticket is sold to whether you're in the right place at the right time to meet someone special. Sequence-of-returns risk shows that timing can be key when it comes to our retirement account withdrawals, too.

The $23,760 Social Security bonus most retirees completely overlook

If you're like most Americans, you're a few years (or more) behind on your retirement savings. But a handful of little-known "Social Security secrets" could help ensure a boost in your retirement income.

One easy trick could pay you as much as $23,760 more... each year! Once you learn how to maximize your Social Security benefits, we think you could retire confidently with the peace of mind we're all after. Join Stock Advisor to learn more about these strategies.

View the "Social Security secrets" »

The Motley Fool has a disclosure policy.