Sequence-of-returns risk

Sequence-of-returns risk arises when money is being taken out of, or added to, a portfolio. With a single lump sum left untouched, the order of annual returns does not affect the end result: a gain of 20% followed by a loss of 10% gives the same outcome as the reverse. Once regular withdrawals begin, that changes. Selling investments after a fall to fund spending locks in losses and leaves fewer units to benefit when markets recover. Two retirees with the same average return over 30 years can therefore end up with very different outcomes, purely because of when the bad years happened.

The risk is greatest in the years just before and after retirement, when the portfolio is usually at its largest and withdrawals are starting. Common ways to manage it include holding a cash or short-term bond buffer to fund a few years of spending so that shares need not be sold in a downturn, reducing withdrawals after bad years, building a bond ladder, or using part of the portfolio to buy an annuity. A frequent mistake is to judge a retirement plan only by average expected returns; the path matters as much as the average. The same effect works in reverse for savers making regular contributions.