Understanding the Impact of Stock Market Fluctuations in Early Retirement

Stock market dips often pose a significant portfolio risk during the initial phase of retirement. Many investors, however, fail to strategize for this risk, warn financial experts. This risk, termed as “sequence of returns risk,” involves the combination of withdrawals timing and stock market losses, which can significantly affect the longevity of your retirement savings.

Key Risks in the Initial Years of Retirement

The initial five years post-retirement is often referred to as the “danger zone” for withdrawing from your accounts during a market downturn, as per Amy Arnott, a portfolio strategist with Morningstar Research Services. If you withdraw from accounts during a market slump, it decreases the amount left in the portfolio to capitalize during a market rebound. Sequence risk can amplify the likelihood of exhausting your retirement savings, alerts Arnott.

The scenario of your portfolio dipping by at least 15% in your first retirement year, coupled with a withdrawal of 3.3% of the balance, can multiply the probability of depleting the portfolio within 30 years sixfold, compared to someone who experiences a positive return in their first year, states a 2022 Morningstar report.

Early Retirement and Negative Returns

According to a 2024 report from Fidelity Investments, negative returns are more detrimental early in retirement. This is because retirees lose more years for potential compound growth. “Early years of positive returns in retirement provide the advantage of the markets working in favor of retirees,” says David Peterson, head of advanced wealth solutions at Fidelity.

Maintaining a Balanced Asset Allocation

As you near retirement, maintaining a ‘balanced asset allocation’ can help in mitigating sequence risk in early retirement years. If your portfolio is 60% stocks and 40% bonds, the sequence risk tends to be lower than portfolios with higher stock allocations. With a well-planned asset allocation, even during a stock market downturn, your portfolio might not experience extreme negative returns. The ideal portfolio mix, however, depends on your individual risk tolerance and financial goals.

Adopting the Bucket Approach in Retirement

Another strategy to shield your portfolio from stock market downturns is adopting the ‘bucket approach.’ Typically, in this strategy, you keep one to two years of living expenses in cash, making it accessible during market dips. The subsequent five years of expenditure could be allocated in short- to intermediate-term bonds or bond funds. Beyond that, the third ‘bucket’ focuses on growth with stocks. Although this strategy requires annual maintenance, it can offer peace of mind by reducing the sequence of returns risk.