Imagine two identical retirees. They have the same nest egg when they retire. They spend the same amount every year. They have the same average investment returns. But after 30 years, one of them still has 96% of their original nest egg while the other only has 29%.
How Can This Be?!
How can this be?! Well...the two retirees are not quite identical.
We left out one important detail. While these two retirees had the same average investment returns, the sequence of their investment returns was different.
The "good luck" retiree saw returns of 10% in Year 1, then 9% in Year 2...down to 1% in Year 10. And then that decade repeated two more times out to 30 years.
The "bad luck" retiree saw the opposite returns. Year 1 was 1%, then Year 2 was 2%...up to 10% in Year 10. And that then decade repeated two more times out to 30 years.
Their average return was identical. But the sequence was different.
This is not an anomaly. This is a well-known investing phenomenon called the "sequence of returns risk."
The Two Risks from Sequence of Returns
The "risk" from a poor sequence of returns has two related components.
The first risk is that a portfolio is hit by poor market performance early in retirement. Why? Because early retirement is (usually) when a portfolio is biggest. A 30% decline of a $1 million portfolio is $300K. Whereas a 30% decline on a $400K portfolio (from later in retirement) is "only" a drop of $120K.
That difference---$300K vs. $120K is $180K---is significant. $180K is enough to fund years of retirement.
The second risk from sequence of returns is that a retiree withdraws significant money while the market is low. For this example, it helps to think in terms of shares rather than dollars.
Perhaps our example retiree needs to sell 400 shares of an index fund in order withdraw one year of spending money. But if the market drops 20%, that retiree would instead need to sell 500 shares of that index fund instead to raise the same amount of spending money.
Once they sell shares, those shares are not coming back! Those shares will no longer pay the retiree dividends, nor will they accrue any capital gains.
Any "unlucky retiree" could need to sell extra shares early in their retirement. That retiree will get no additional benefit from those shares.
But a "lucky retiree" will be holding onto those extra shares. In fact, a good stock market might even mean that a "lucky retiree" gets to keep more shares than they originally anticipated. And those extra shares will pay long-term dividends...literally!
How To Reduce Your Sequence of Returns Risk
There are two important tactics to reducing your sequence of returns risk.
The first: build slack into your portfolio. This slack can come in the form of extra savings or diversification or both.
Extra savings simply means that you save up a little bit more than you need. It is a safety net, just in case. When a bad investment period strikes, that safety net provides a buffer.
Diversification means that your portfolio is constructed such that the investment returns are reasonably stable. (Though probably not perfectly stable---that is a rare feat.) But stable enough so that you are not affected by huge market swings in either direction. This stability makes planning much easier.
And once that slack is built into your portfolio, the second tactic to reduce your sequence of returns risk is to maintain flexibility. Specifically, we mean the flexibility to temporarily change your annual spending if needed.
Let’s go back to the "unlucky retiree" who withdrew 500 shares instead of their planned 400 shares. A more flexible retiree might have asked, "Could I live off less money this year---and only withdraw 450 shares? Or 425 shares? Or even the originally planned 400 shares?"
This ability to "roll with the punches" will maintain your nest egg's health, even if a poor sequence of returns comes your way.
Summary
Sequence of returns risk exposes the difference between average investment returns and actual investment returns. If a poor sequence of returns occurs at the wrong time, it can cause long-lasting damage to a retirement nest egg. But every retiree should be aware that they have tools in their arsenal to protect themselves.