Understanding Sequence of Returns Risk

All right. When you're planning for retirement, what's the one number we're all taught to focus on? That big, beautiful average annual return, right? But what if I told you that number can be a bit of a trap? There's a hidden danger, especially right when you stop working, where that average can be seriously misleading. So, let's break down what this risk is and more importantly, how it actually works. So, let's put a name to this thing. We're talking about a critical factor in retirement planning called the sequence of returns risk. I know it's a wild idea, isn't it? We spend our entire careers trying to get the highest possible average return. But for retirees, it turns out that when you get your returns can be just as important as what those returns are, maybe even more so. So, here's the deal in a nutshell. Sequence of returns risk is the danger that a big market crash right at the start of your retirement could have a devastating long-term impact. And why is that? Because you're not just saving anymore. You're actively pulling money out to live on. And that one change makes all the difference. Let's see how this plays out in the real world. To really see this thing in action, let's walk through our first scenario. We'll call this one a bad start. Here's the setup. A retiree starts off in a great spot. A million in the bank. The plan is to withdraw $100,000 every year. Now, pay really close attention to these market returns. It's a nasty 50% drop in year 1, then a few years of going nowhere, followed by a massive 100% gain in the final year. So, year zero, we start with a million dollar nest egg. Everything's looking good. But then boom, disaster strikes in year one. The market gets cut in half. So that million-doll portfolio is suddenly worth just 500,000. And from that, our retirees still has to take out their hundred grand to live on. That leaves them with just $400,000 after a single year. That is a massive, massive blow. For the next few years, the market is totally flat. But those annual withdrawals just keep coming out, eating away at that smaller pile of money. By the time you get to the end of year four, the portfolio has just dwindled down to $100,000. And here's the full picture. You see that huge 100% gain at the very end. You'd think that would save the day, but it's too little too late. Doubling $100,000 only gets you back to 200,000. The portfolio never recovers because that initial loss combined with the withdrawals was just catastrophic. Okay, now let's look at scenario two. A good start. This retiree has the exact same starting money, the same average returns. We're just flipping the order. See what we did? We just inverted the returns. This time, our retiree gets that incredible 100% gain in their very first year. Then come the flight years, and that awful 50% loss happens at the very end. And the result is explosive. The $1 million portfolio doubles to 2 million bucks. a retiree takes out their $100,000 and they're still left with an incredible 1.9 million. I mean, that's just a world of difference. This chart for this scenario tells a completely different story. That huge gain right at the start creates such a large cushion that the portfolio can easily handle the withdrawals later on. And even that 50% drop at the end. Instead of running out of money, this retiree ends with a really healthy balance of well over half a million dollars. So, what is going on here? Same amount of money, same withdrawals, same average returns over the long run. Why are the outcomes so wildly different? Looking at them side by side really just drives the point home, doesn't it? On the left, you've got financial ruin. On the right, a comfortable retirement. The only thing that changed was the sequence, the order of those market returns. Okay, here's the critical difference. If you were still working and just buying and holding investments, the order wouldn't matter. A 50% drop followed by a 100% gain gets you right back where you started. But when you were a retiree, you have to sell assets to generate income. In that bad first scenario, you're forced to sell when your assets are worth half as much. You're selling low. This locks in your losses permanently and means you have way less capital left to benefit from the recovery when it eventually comes. So, does this mean your retirement is just a matter of dumb luck? Not at all. The good news is there are concrete strategies you can use to protect your portfolio from this very risk. It's the most important question, isn't it? How do you defend yourself against a bad sequence of returns that you can't possibly predict? While the key is to reduce the wild swings in your portfolio, the volatility. While stocks are great for long-term growth, other assets like bonds or gold often move differently and they can act as a buffer when the stock market is tanking. By holding a diversified mix, you have more stable things you can sell for income when your stocks are down. That gives your stocks time to recover, and it helps you avoid selling them at the absolute worst time. And that brings us to the single most important idea to take away from all of this. We hear it all the time, don't try to time the market. And that's true. But what this risk shows is that ready or not, the market might just time you. The market's performance in your first few years of retirement can have a massive outsized impact on the rest of your life. And just understanding that that's the first and most important step to preparing for it.