Sequence-of-Returns + Concentration Risk: A Case-Based Framework to Stress-Test Pre-Retiree Portfolios

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The last years before retirement are usually accompanied by simultaneous excitement and anxiety . After carefully saving and investing money for decades, you’re finally nearing the finish line. You’ve checked your account balance, and you’re set to begin the next chapter of your life. But then you may ask yourself a question: Could the success of your retirement depend not only on how much you’ve saved, but also on when you retire and how your assets have been invested?

There are two significant risks associated with a retirement plan, both of which have long, technical names: sequence-of-returns risk and concentration risk. Understanding them is the first step to protecting your nest egg. Let’s find out what they mean by looking at some examples.

Understanding the Sequence of Returns

Consider two friends, Bob and Charles, who both worked for 40 years. They have similar retirement portfolios, each valued at around $1 million. They plan to withdraw $50,000 a year for living expenses. However, they retire a few years apart and experience very different market conditions.

Bob retires, and in his first year, the market soars 20%. In his second year, it climbs another 15%. By the time the market eventually has a bad year, his portfolio has grown so much that the downturn doesn’t cause him much stress. He’s comfortably ahead.

Charles, on the other hand, isn’t doing so well. He retires, and the market drops 20%. His $1 million is reduced to $800,000. He still needs to withdraw $50,000 to live on, taking his balance down to $750,000. Next year, the market is flat, and he withdraws another $50,000. In just two years, his nest egg has declined by 30%. He’s taking money out of a shrinking portfolio.

This illustrates the sequence of returns risk. Two people had the same amount of money and living expenses. The only difference was the timing. Bad returns, due to conditions you can’t predict or control, in the first few years of retirement, can be devastating.

Understanding Concentration Risk

Now let’s consider another pre-retiree. For 30 years, Alice worked for a large technology company. She was a loyal employee and enthusiastically participated in the employee stock purchase plan. Over the decades, she accumulated a large number of shares. By the time she was ready to retire, 70% of her $1.5 million retirement portfolio was in her company’s stock.

This strategy was a winner for years. The stock had performed brilliantly, and her friends even called her a stock market wizard. But then a new competitor unveiled a revolutionary product, and her company’s market share began to plummet. The stock price fell 50% in six months. Alice’s portfolio, once worth $1.5 million, was now worth less than $1 million. She put too many of her eggs in one basket.

This is a concentration risk. While having most of your investments in a single stock or industry sometimes leads to spectacular gains, it also exposes you to considerable risk. For the pre-retiree who doesn’t have decades to recover, the result can be a permanently diminished retirement. The primary defense against this risk is diversification, which involves spreading your investments across multiple assets.

A Framework to Stress-Test Your Portfolio

You don’t need to be a financial genius to protect yourself from retirement risks. The goal is to build a portfolio that is resilient enough to withstand a storm. Here are a few questions to ask yourself or your financial advisor to “stress test” your own plan:

What If I’m Unlucky?

Ask your advisor to run a simulation showing what would happen to your portfolio if the market dropped significantly in your first two years of retirement. If the answer is that you’d run out of money ten years too soon, your plan isn’t resilient enough.

Where Is My Concentration?

Look at your portfolio. Is there any single stock that makes up more than 5%-10% of the total? What about a single industry, like technology or energy? Imagine that this holding was cut in half tomorrow. Could you still afford to retire?

Do You Have a Plan for the “Danger Zone”?

This is the five-year period before and after your retirement when the sequence of returns matters the most. Have you discussed a plan with your advisor to be more conservative in this phase to protect your principal?

Be Willing to Change Your Strategy

You don’t want to risk it with retirement. No one knows how markets will perform in any particular period. Nor do we know when a specific asset or industry will suffer losses. By understanding these risks and asking the right questions, you can take ownership of your financial future and ensure that the decades of hard work you've invested pay off.

D. Daxton White, managing partner of the White Law Group, is a securities attorney licensed in Florida and Illinois with a 10.0 Avvo rating and AV rating from Martindale Hubbell. A Northwestern and Florida State law graduate, he has handled over 700 FINRA arbitration cases and formerly worked for major broker-dealers and the NASD. He now exclusively represents investors nationwide in securities fraud claims and is a frequent lecturer on FINRA arbitration.

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