You've heard that stocks return about 10% annually over the long term. But here's a dangerous truth: two investors with identical average returns can have vastly different outcomes. The difference? The order in which those returns occur. This is sequence of returns risk—and it can make or break your retirement.
The Sequence Matters
Consider two retirees, each starting with $1 million and withdrawing $50,000 annually. Both experience the same returns over 20 years—just in reverse order.
Retiree A: Bad returns early
Years 1-5: -15%, -10%, +5%, +8%, +12%
Years 6-20: Mix of positive returns averaging 8%
Retiree B: Good returns early
Years 1-5: +12%, +8%, +5%, -10%, -15%
Years 6-20: Same mix as Retiree A (same returns, reversed)
Both experience identical average returns. But Retiree A, who faced losses while withdrawing $50,000/year, runs out of money by year 18. Retiree B ends up with over $800,000 remaining.
Same average return. Completely different outcomes. That's sequence risk.
Why This Happens
During accumulation (your working years), sequence doesn't matter much. A 30-year-old with 35 years until retirement can weather early losses—those shares bought low will eventually recover and grow.
But in retirement, you're withdrawing, not adding. When the market drops and you sell shares to meet expenses, those shares are gone forever. They can't participate in the recovery. You've locked in losses at the worst possible time.
The math is brutal: a 30% portfolio drop requires a 43% gain to recover. But if you're also withdrawing 4-5% annually, you need even larger gains—gains that may never come quickly enough.
The Danger Zone
The five years before and the five years after retirement are the most critical. Researchers call this the "retirement red zone." A major bear market during this window can permanently impair your retirement security.
Why? Because during this period:
- Your portfolio is likely at its largest (most dollars at risk)
- You're about to start—or have just started—withdrawals
- You have limited ability to "wait it out" or add more savings
- Psychological pressure is highest (you might panic-sell)
The Zen Take
You can't control market returns. But you can control your portfolio's vulnerability to poor early returns. The transition from accumulation to distribution is the most dangerous moment in your financial life. It deserves careful planning and risk management, not a continuation of aggressive strategies that served you well in your 30s.
Strategies to Mitigate Sequence Risk
1. Build a cash/bond buffer
Hold 2-5 years of expenses in cash and short-term bonds as you approach and enter retirement. This allows you to fund withdrawals without selling stocks during downturns. The "bucket strategy" formalizes this approach.
2. Reduce equity exposure gradually
The old rule of "100 minus your age in stocks" was too conservative for accumulation but makes more sense approaching retirement. Consider reducing from 80-90% stocks to 50-60% as you enter the red zone.
Some advocate a "rising equity glidepath"—starting retirement with lower stock allocation and gradually increasing it. Early low exposure reduces sequence risk; later higher exposure provides growth and inflation protection.
3. Maintain withdrawal flexibility
A rigid 4% withdrawal regardless of market conditions amplifies sequence risk. Build flexibility into your spending:
- Reduce discretionary spending after bad years
- Use guardrails that adjust withdrawals based on portfolio performance
- Cover essential expenses with guaranteed income (Social Security, pensions, annuities)
4. Delay Social Security
Delaying Social Security to 70 while drawing from your portfolio in your 60s serves two purposes: it increases your guaranteed income later, and it allows portfolio withdrawals before you're fully dependent on the portfolio. If markets cooperate, great. If not, you have larger Social Security to fall back on.
5. Consider partial annuitization
Using a portion of savings to purchase a single premium immediate annuity (SPIA) creates guaranteed income that's immune to sequence risk. This isn't right for everyone, but for those worried about outliving their money, it provides certainty.
6. Maintain some earning capacity
Part-time work in early retirement provides income that reduces portfolio withdrawals during potentially vulnerable years. Even modest earnings ($20,000-$30,000/year) significantly reduce sequence risk.
What Not to Do
Don't go to 100% bonds. While reducing stocks helps, going too conservative creates different risks: inflation erosion and longevity risk (outliving your money). You still need growth.
Don't try to time the market. Moving to cash before an expected crash sounds smart, but timing consistently is nearly impossible. You're as likely to miss the recovery as avoid the crash.
Don't panic sell. If you're in the red zone and markets crash, the worst thing you can do is sell everything. You've already experienced the loss; selling locks it in and prevents recovery.
Running the Numbers
Use retirement planning software that incorporates sequence risk through Monte Carlo simulations. These run thousands of scenarios with different return sequences to estimate the probability of success.
Key metrics to watch:
- Success rate: What percentage of scenarios don't run out of money?
- Failure scenarios: What happens in the worst 10% of cases?
- Median outcome: What's the typical ending balance?
Aim for 85-95% success rates. 100% success means you're probably too conservative and will leave money on the table.
The Reality Check
Sequence risk is real, but it's not a reason to panic. Most historical periods have been kind to retirees. The 4% rule, despite criticism, has worked more often than not.
What sequence risk demands is awareness and planning—not paranoia. Build flexibility into your retirement, maintain some buffer against bad early returns, and have a plan for what you'll do if markets disappoint in your first years of retirement.
The goal isn't to eliminate all risk—it's to ensure that even in poor scenarios, you'll be okay. That's achievable with thoughtful planning.