Also called: Sequence risk, Order of returns risk.
Two retirees can earn exactly the same average annual return over thirty years and end up in completely different places. If one of them meets the bad years first, they sell assets into a falling market to fund spending, and those shares are gone before the recovery arrives. The other meets the same bad years at the end, by which point the portfolio has already compounded.
This is why averages are close to useless for anyone drawing down a portfolio. During accumulation the effect runs the other way and is mostly benign — a crash early in a saving career is a discount, because you keep buying. During decumulation it is the single largest threat to a plan that otherwise looks healthy.
The window where it bites hardest is roughly the five years either side of retirement, sometimes called the retirement red zone. That is when the portfolio is at its largest and contributions have stopped, so a drawdown does maximum damage and has no new money to work against it.
The defences are all forms of flexibility: holding a cash or bond buffer to avoid selling equities at a low, using a withdrawal rule that cuts spending after bad years, or working a little longer. Our own simulation found that the same 40% crash cut a plan’s success rate from 86% to 71% when it landed at retirement age 65, but only to 81% when it landed at 48.
Research on this
- Sequence of Returns Risk: What If the Market Crashes the Year You Retire?
- Is the 4% Rule Still Safe? We Ran 5,000 Simulated Retirements
See also
- Safe withdrawal rate — The share of a portfolio’s starting value you can withdraw in year one of retirement, then raise with inflation each year, without running out over your horizon.
- Decumulation — The phase in which a portfolio is being spent rather than built, and the set of decisions — how much to withdraw, from which accounts, in what order — that go with it.
- Guardrails (Guyton-Klinger) — A withdrawal policy that starts from fixed spending, then cuts it when the withdrawal rate breaches an upper band and raises it when it falls below a lower one.
- Drawdown — The percentage fall from a portfolio’s previous peak to its lowest subsequent point. Maximum drawdown is the largest such fall over a period.