Understanding Sequence of Returns Risk
A critical risk factor that can make or break your retirement portfolio, regardless of average returns
What is Sequence of Returns Risk
It is the danger that poor market performance early in retirement severely depletes your portfolio.
The order of investment returns is critical when you are making withdrawals.
A market downturn early in retirement has a greater impact than a later one.
Early poor returns can create a deficit that is difficult to overcome.
This risk primarily applies once you’ve retired and are generating income from your portfolio. Early poor returns create a deficit that compounds with each withdrawal as losses get locked in.
Example - Initial Loss
Starting Scenario
Initial Balance: $1,000,000
Annual Withdrawal: $100,000
Simulated Market Returns
Year 1: -50% loss
Years 2–4: 0% change
Final Year: +100% gain
Critical Insight: A significant early market loss, combined with ongoing withdrawals, severely depleted the portfolio. The early withdrawals meant less capital remained to benefit from the final year’s 100% recovery, resulting in a much lower final balance than the returns alone would suggest. I.E. withdrawals “locked in” the losses.
Example - Initial Gain
Starting Scenario
Initial Balance: $1,000,000
Annual Withdrawal: $100,000
Simulated Market Returns
Year 1: +100% gain
Years 2–4: 0% change
Final Year: -50% loss
Critical Insight: The opposite is true with high gains. With no net return, and annual withdrawals of $100K, you would expect a balance of $500K. But the account has a higher balance as the withdrawals were at an inflated account balance.
A buy and hold investor would have exited either scenario with the balance unchanged at $1M.
Key Takeaways
Timing matters
The order in which your investment returns occur is as critical as the average return, particularly when withdrawing funds for income.
Volatility and Withdrawals
High-volatility, high-return investments may leave your portfolio poorer than lower-return investments if you are drawing down the principal for income.
Mitigation
Diversified portfolios (including stocks, bonds, gold, etc.) can be used to reduce volatility and, consequently, mitigate Sequence of Returns Risk.
A successful retirement has an element of luck, as the sequence of returns, not just the average, significantly affects your final account balance.
You may not time the market, but it may time you.
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