How to Avoid Sequence Risk

You’ve saved up enough money to be able to withdraw 4% every year and that number is more than your minimum income requirement.

So, you’re all set, right? You did it right and you made it!

Not really… Here’s why.

The 4% rule isn’t adequate because it makes an assumption about constant market conditions.

What if a major event happens during your first year or two of retirement. What if you retired in 2006 for example?

Compare this to a person who retires and doesn’t have a major market correction happen for 10 or 15 years.

The order which you withdraw from your retirement and when natural market corrections happen is important.

What is Sequence Risk

Sequence risk is the risk of a major market correction happening during the beginning few years of your retirement. The reduction in your portfolio could be substantial enough that your retirement fund may never recover if you continue to withdraw from it to pay for living expenses.

This will force you to either risk running out of money, or leaving retirement to continue working.

The key to this happening is that many people cannot take a percentage of their portfolio, but must take a fixed amount each year.

So, if your $1,000,000 portfolio supports your $40,000 lifestyle right now that’s great. But, if your portfolio loses half its value (hey, it happens!), can you live on $20,000 or do you still need to withdraw $40,000?

If you continue to withdraw the fixed sum, you run the risk of future gains never catching up to where you need to be.

Sequence risk is impossible to control since you can’t control your age or the economy.

All you can do is adapt your investing style and portfolio to accommodate this.

The Traditional Way to Avoid Sequence Risk

Traditionally, financial advisers recommend allocating more of your portfolio into less risky assets as you get older. Your returns go way down (as low as 2 or 3%) but the risk of losing the principal drops way off.

It’s the classic risk vs reward scenario. Reduce risk by seeking safer assets at a lower yield.

The problem with this is you need to dramatically reduce the amount you withdraw. The other option is to double the amount of money saved so you can live on 2% of your principal.

Another way to avoid the risk, or to mitigate the effects of a crash is to get a job. A lot of elderly people did this during the last recession.

You do what you need to do in order to survive, but it’s probably not great advice overall. You’re supposed to be retired, so “getting a job” to avoid the risk of your portfolio running out before you die isn’t really a solution to keep you retired.

The other problem is there aren’t a lot of jobs available when the economy is bad. Plus, once you’re out of the market for a while you become mostly unemployable. So, you need to consider the reality that you might have a mostly entry level job at a wage far below what you used to earn.

Appreciation vs Yield

Just to keep our terminology straight across sectors, we’re going to call the increased stock price as “appreciation” and any dividends they provide I might also call cash flow.

Using this terminology, we can say that stocks appreciate nicely over the years but throw off very little cash flow.

That’s the big problem with investing in stocks – you generally need to sell them in order to get access to your earnings. Some stocks have high dividends, but most do not.

So, you’re selling a shrinking number of higher valued shares. It just seems odd to me.

The average dividend for the S&P 500 is 2%, so if you can live on 2% of your portfolio balance, then you could, in theory, live entirely on dividends and have a well balanced portfolio.

Most of us cannot do that.

Diversification Helps Avoid Sequence Risk

I always harp on this. Diversification doesn’t mean buying some energy stocks, some tech stocks, some banking stocks, etc.

That’s still all stocks.

Buying some bonds is technically diversification. So that’s a start, but it doesn’t really solve both sets of issues. It reduces risk but kills your returns.

Is there some way to reduce the risk of fluctuating market cycles by moving your investments from high appreciation assets to something that has high cash flow instead?

What you need is real estate.

Real Estate to Balance Your Portfolio

We’re talking about commercial real estate (CRE) not single-family residences. Single-family homes are based on comparable sales and not on their net income, so for this article, we aren’t focused on them.

What we’re talking about is multifamily, self-storage, NNN property, retail, etc. They are built for the purpose of investments.

These real estate assets are valued based on the actual cash they produce each year and are not valued based on the whims of your neighbors.

Their value is determined by what’s called the capitalization rate. In a nutshell, the cap rate is what yearly cash flow you would get if you bought the property in all cash and had no mortgage. They fluctuate from area to area and right now range anywhere from 3% to 7% in major cities depending on the type of asset, location, age, risk, etc. 

Generally, if you get a mortgage then the cash flow will be higher as a percentage of your total investment. 

How it Offsets Sequence Risk

Real estate is a good way to balance sequence risk because the real estate markets do not run in sync with the broader market. For example, the stock market recently dropped over 20% but rents and property values continued to climb.

Often, rent prices can run counter cyclical with home values – meaning when people lose their homes they need to rent instead.

Additionally, real estate is a high cash flow asset with lower appreciation. Generally, you can return 6 – 10% (more or less depending on your location) in cash flow and also get 2% or more in appreciation. So, the overall returns can be similar as stocks if you have unleveraged real estate, but they give way more cash flow and less appreciation.

This means you don’t need to sell assets to live on the money.

So, real estate makes for a perfectly opposite investment to avoid sequence risk.

Adding Real Estate to Your Portfolio

There are a ton of other benefits to real estate that we didn’t talk about including depreciation, real estate as a tax shelter, and more.

So, if you’re wondering how to add real estate to your portfolio here are the 3 most common ways.

Buy Rental Property Yourself

The most obvious way is to use some money and go get some rental property for yourself. There is a lot to it, so if this is what you want to do go read this intro article on becoming a real estate investor.

These next options are how you can add real estate to your portfolio without becoming a landlord.

Real Estate Crowdfunding

The next closest thing to owning real estate is to pool your money with other investors and invest in a way that is now called crowdfunding.

With this option you are gaining direct ownership over the real estate without being involved in all the nitty-gritty details.

There are three main pioneers in this space right now.

Fundrise is a platform where they pool your money together and buy real estate, give loans, and invest your money. It’s good because the risk is spread out across a lot of assets.

EquityMultiple is a place where you can invest in a single investment property. They only invest in institutional grade assets, so you’re buying huge apartment buildings for example. This is great because you can control exactly which asset you are allocating your money to.

RealtyMogul is similar to the two above and they have both a pooled fund like Fundrise and there are also options to invest individually like EquityMultiple.

All three are free to sign up, so definitely sign up for them, check out what they offer, and compare your options before making an investment decision.

REITs and Funds

Real Estate Investment Trusts and Real Estate Funds are generally traded on the stock market and you can buy and sell them like stocks.

While they act like stocks, their underlying asset is the real estate they hold and the cash flow that produces.

You have a huge amount of options to choose from and you buy them the same way you buy stocks from your brokerage.

Are You Adding Real Estate?

Even if you have a great nest egg that’s properly invested, you may still have some risks when you plan to retire. 

Real estate can help you avoid those risks and still earn a healthy return.

It is a high cash flowing asset so you don’t have to sell it in order to live on the income. Additionally, you don’t have to become a landlord if you choose to do crowdfunding or buy REITs or RE ETFs.

Are you adding real estate to your portfolio? If so, how are you doing it?