Sequence of Returns Risk
The danger that poor investment returns early in retirement — when withdrawals are largest relative to the portfolio — can permanently deplete a portfolio even if long-run average returns are adequate.
What is Sequence of Returns Risk?
Sequence of returns risk (also called sequence risk or path dependency) is the danger that the order of investment returns — not just the average — critically affects retirement outcomes when ongoing withdrawals are being made. Two portfolios with identical 20-year average returns can produce vastly different final balances if one experiences losses early (while the portfolio is largest and withdrawals are highest) while the other experiences gains early. A retiree who withdraws $50,000/year from a $1 million portfolio and experiences a 30% loss in year 1 is left with only $650,000 — from which they must continue withdrawing. If they then recover strongly, the remaining portfolio is too small to benefit fully. The reverse — early gains, late losses — is far less damaging because the portfolio has grown substantially before losses hit. Sequence risk is the primary justification for the 4% safe withdrawal rate, dynamic withdrawal strategies, bond glide paths, and cash buckets in retirement portfolios.
Example
Two retirees each start with $1M and withdraw $50,000/year. Retiree A experiences −30%, +15%, +15% in years 1–3; Retiree B experiences +15%, +15%, −30%. Both average the same 0% three-year return. After 3 years, Retiree A has $590,250; Retiree B has $812,750 — a $222,500 difference from identical average returns but different sequencing. Retiree A's portfolio may never recover.