What is sequence-of-returns risk?

Sequence-of-returns risk is the risk that the order in which returns arrive harms a portfolio from which money is regularly withdrawn. Without withdrawals, the order does not matter: the same returns in any order produce the same final value. With withdrawals — as in retirement — bad years early on do far more damage than the same bad years later, because money is taken out while values are low and is no longer there for the recovery.

Why the order matters

Without cash flows, the final value depends only on the product of the returns, which is the same in any order:

V_n = V_0 \prod_{t=1}^{n} (1 + r_t)

With a withdrawal $W$ at the end of each year, every year's value depends on everything that came before:

V_t = V_{t-1} \, (1 + r_t) - W

A withdrawal taken after a fall sells more shares for the same amount, leaving fewer shares to benefit when prices recover.

A simple illustration

Two retirees each start with €500,000 and withdraw €30,000 a year. Both experience the same five yearly returns, in opposite orders:

	Bad years first	Good years first
Returns	−20%, −10%, +15%, +20%, +10%	+10%, +20%, +15%, −10%, −20%
Value after five years	€357,354	€416,232

Without withdrawals, both would have exactly €546,480, because the returns are the same. With withdrawals, the retiree who met the bad years first has about €59,000 less after only five years. Over a retirement of thirty years, a difference like this can decide whether the money lasts.

When it matters most

In the years just before and after retirement, when the portfolio is largest and withdrawals begin.
With high withdrawal rates, which leave less room to recover.
In portfolios with a high share of volatile assets.

Ways to reduce it

A cash or bond buffer covering a few years of withdrawals, so that stocks need not be sold after a crash.
Flexible withdrawals: spending somewhat less after bad years and more after good ones.
A lower starting withdrawal rate, such as the conservative rates discussed around the 4% rule.
Reducing risk gradually in the years around the start of withdrawals.

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