Sequence of Returns Risk

If money simply sits in a portfolio, the order of returns makes no difference. A 20% loss followed by a 25% gain leaves you exactly where you started, and so does the gain followed by the loss, because multiplication gives the same answer in any order.

Withdrawals break that symmetry. Money taken out after a loss comes from a smaller pot, so each dollar of spending sells a larger share of the portfolio, and the shares sold are gone before any recovery. It is the mirror image of dollar-cost averaging, sometimes called reverse dollar-cost averaging: a saver buying steadily through a slump gets more shares for the same money, while a retiree selling steadily through one gives up more shares for the same spending.

So an average return, even a correct one, can mislead a retiree. William Bengen made the point in his 1994 study of withdrawal rates, the research behind the 4% rule: plans built on average returns and average inflation missed what actual year-by-year history did to portfolios. Volatility supplies the ups and downs, but the timing of the bad years relative to your withdrawals is what does the damage.

Exposure peaks in the years around the retirement date, a span sometimes called the retirement red zone, when the balance is at its largest and the cash flow switches from contributions to withdrawals. A large loss then meets the most money you will ever have, with little or no saving left to rebuild it.

The first decade of retirement matters most, because a loss then has the longest run of withdrawals left to compound through. It does not end there, though. In Bengen’s data, the 1973–1974 bear market, which came with high inflation, still shortened portfolios whose withdrawals had begun two decades earlier. Those who retired just before it fared worst: at a 5% withdrawal rate, retirements starting in the late 1960s and early 1970s might have lasted only about 20 years.

Regulators make the same point. FINRA’s investor guidance notes that retirees may no longer have time to recover from downturns and makes the case for starting withdrawals conservatively, and the SEC says market swings and longer life expectancies argue for conservative withdrawals, especially in the first years of retirement. A long retirement stretches the exposure further, which is how sequence risk and longevity risk compound each other.

You cannot choose the order in which markets deliver returns, but you can make a bad order hurt less. Every method works in one of three ways: it avoids selling stocks right after a loss, it cuts how much you sell, or it covers essential spending from a source that does not depend on markets.

A bucket strategy holds a few years of spending in cash and bonds. Dynamic spending rules such as guardrails trim withdrawals after losses. A rising-equity glide path holds more bonds around the retirement date and shifts back toward stocks later. Part-time work in the early years, as in semi-retirement, shrinks withdrawals exactly when they do the most damage, and a lower starting withdrawal rate leaves more room for a bad first decade.

Each approach costs something, usually expected growth or predictable income, so many retirees combine two or three. The table below sets out the trade-offs.

A single projection at a steady average return cannot show sequence risk at all, because every year earns the same. To see it, your plan has to live through uneven years, and there are three common ways to make it do so.

A historical backtest runs the plan through each real stretch of past returns in the order it happened, such as a retirement beginning in 1929 or 1973. A Monte Carlo simulation builds hundreds or thousands of possible sequences and reports the share in which the money lasts. A targeted stress test places one bad sequence, such as a crash, on your first retired year and then on a year a decade later. The gap between those two versions of the same plan is the most direct measure of your own sequence risk.