Sequence of Returns Risk

Sequence of Returns Risk is the financial gremlin that haunts retirees. It's the danger that the order in which your investment returns occur can have a far greater impact on your portfolio's longevity than the average return itself. Imagine you’ve spent decades diligently building your nest egg. Now, in retirement, you start making withdrawals. If the market tanks right after you retire, you're forced to sell more of your investments at low prices to fund your lifestyle. This triple-whammy of market losses, withdrawals, and selling low can permanently cripple your portfolio, making it incredibly difficult to recover even when the good years eventually arrive. Conversely, if you enjoy strong returns in the early years of retirement, your portfolio can grow even as you draw from it, setting you up for a much more secure future. This risk is most acute for those in the “decumulation” phase (spending down) rather than the “accumulation” phase (building up).

During your working years (the accumulation phase), a market downturn can actually be a blessing in disguise. It allows you to buy more shares of great companies at lower prices, a practice related to dollar-cost averaging. Your regular contributions scoop up bargains, and when the market recovers, your portfolio bounces back with even greater force. Retirement flips this script on its head. When you start withdrawing money, a bear market becomes your worst enemy. You are no longer adding money; you are taking it out. Selling assets in a down market to cover living expenses means you are liquidating a larger percentage of your portfolio, leaving less capital to participate in the eventual recovery. This is how two people with the exact same average investment return over 20 years can have wildly different outcomes—one might run out of money, while the other leaves a hefty inheritance. It all comes down to the sequence of those returns.

Let’s meet Prudence and Unlucky Gus. Both are sensible investors, both retire with a $1,000,000 portfolio, and both plan to withdraw $50,000 at the end of each year for living expenses. Over the first three years of their retirement, the market produces annual returns of -15%, +10%, and +20%. The only difference is the order in which they experience them.

Prudence retires just as a bull market begins. Her returns are front-loaded.

• Starting Portfolio: $1,000,000
• Year 1: Strong start!
  1. Return: +20% ($1,000,000 x 1.20 = $1,200,000)
  2. Withdrawal: -$50,000
  3. End of Year 1 Balance: $1,150,000
• Year 2: Another good year.
  1. Return: +10% ($1,150,000 x 1.10 = $1,265,000)
  2. Withdrawal: -$50,000
  3. End of Year 2 Balance: $1,215,000
• Year 3: The market finally dips.
  1. Return: -15% ($1,215,000 x 0.85 = $1,032,750)
  2. Withdrawal: -$50,000
  3. End of Year 3 Balance: $982,750

Gus has the rotten luck of retiring right at the start of a market downturn.

• Starting Portfolio: $1,000,000
• Year 1: A terrible start.
  1. Return: -15% ($1,000,000 x 0.85 = $850,000)
  2. Withdrawal: -$50,000
  3. End of Year 1 Balance: $800,000
• Year 2: The market recovers a bit.
  1. Return: +10% ($800,000 x 1.10 = $880,000)
  2. Withdrawal: -$50,000
  3. End of Year 2 Balance: $830,000
• Year 3: A strong year, but is it enough?
  1. Return: +20% ($830,000 x 1.20 = $996,000)
  2. Withdrawal: -$50,000
  3. End of Year 3 Balance: $946,000

Both investors experienced the exact same average returns, yet after only three years, Prudence has $36,750 more than Gus. The early losses forced Gus to sell from a shrunken portfolio, a hole from which it's very difficult to dig out.

Fortunately, sequence of returns risk is not a matter of pure luck. A sound value investing philosophy provides several powerful tools to manage it.

This is your primary buffer. The idea is to hold one to three years' worth of living expenses in safe, liquid assets like cash, high-quality bonds, or money market funds. When the stock market is down, you draw from this cash bucket instead of selling your stocks at a loss. This gives your equity portfolio precious time to recover without being depleted by withdrawals.

The old “4% rule” can be too rigid. A smarter approach is to be flexible. When markets are soaring, you might take out a little extra for a nice vacation. When markets are falling, you tighten your belt and withdraw less. This “guardrail” approach helps preserve your capital during the most dangerous periods, ensuring your portfolio lasts longer.

A 100% stock portfolio in retirement is a recipe for sequence risk disaster. A prudent asset allocation strategy is crucial. By blending stocks (for long-term growth) with less volatile assets like bonds, you create a more stable portfolio. The bond portion acts as a shock absorber during market downturns and can be a source of funds for withdrawals, further protecting your stocks from being sold at the worst possible time.

This is the heart of value investing. By buying wonderful businesses only when they trade at a significant discount to their intrinsic value, you build in a margin of safety. These high-quality, financially resilient companies are often better able to weather economic storms. Furthermore, many pay reliable dividends, which provide a steady stream of cash flow you can use for living expenses, reducing the need to sell shares altogether, regardless of what the market is doing.