Sequence of Returns Risk

Sequence risk is the fact that the order of returns matters as soon as money is moving in or out of a portfolio. Two retirees can experience the identical set of annual returns in different orders, end with the identical average, and reach completely different outcomes — one comfortable, one out of money.

The mechanism is simple arithmetic. Withdrawing during a decline sells more shares to raise the same dollar amount, so those shares are gone when the recovery arrives. A 30% loss in year one of retirement is compounded by the spending that happens on top of it, and the portfolio has a permanently smaller base to grow from.

This is why averages are misleading in the withdrawal phase and harmless in the accumulation phase. While you are still contributing, a long early slump is actually helpful — every contribution buys more shares cheaply. The danger window is roughly the five years either side of retirement, when the balance is at its largest and the contributions stop.

The standard defenses all reduce forced selling rather than trying to predict markets. Holding one to three years of spending in cash and short-term bonds lets you fund a bad year without touching equities; a rising equity glide path starts retirement more conservative and grows riskier as the danger window passes; and flexible spending — deferring an inflation increase or a large discretionary purchase after a down year — is the cheapest lever of all.

It is also the reason the safe withdrawal rate exists as a concept. That research is essentially an attempt to size sequence risk: the 4% figure is not the historical average return, it is what survived the worst historical sequences.