Sequence of Returns Risk: Why the ORDER of Your Returns Matters

Two investors can have the same average annual return over 20 years, say 7% per year. Yet, they can end up with very different results. This happens because of which specific years the good and bad returns occur. This is known as sequence of returns risk. It highlights that the order in which returns happen, not just their long-run average, can greatly impact your final outcome. This is especially true when you’re making regular contributions or withdrawals alongside the investment returns.

The effect is clearer when withdrawals come into play. Picture two retirees. They each start retirement with the same portfolio balance and withdraw the same amount each year. They also experience the same annual returns, just in reverse order. The retiree who faces poor returns first sees their portfolio shrink due to both bad returns and ongoing withdrawals. When withdrawals happen during a depleted portfolio, they take a larger share of what’s left. This leaves much less capital to benefit from a possible recovery, even if that recovery does come. On the other hand, the retiree who experiences those poor returns last, after years of growth, is in a much better position. Their portfolio had already grown larger and could better handle the downturn before the bad returns hit.