Week 12 Day 1: The Order of Returns Matters

Imagine two retirees: both get 7% average return over 20 years. Retiree A gets bad years first (crashes early), then good years later. Retiree B gets good years first, then bad years later. If both are withdrawing 4%, Retiree A may run out of money while Retiree B is fine. Same average return. Different sequence. Different outcome.

Here is a concrete example. Both retirees start with $1,000,000 and withdraw $40,000/year (4%). Both experience the same returns, just in different order. Retiree A's first 5 years: -15%, -10%, +5%, +20%, +25%. Retiree B's first 5 years: +25%, +20%, +5%, -10%, -15%. After 5 years with identical average returns: Retiree A has roughly $770,000 (early losses plus withdrawals depleted the base). Retiree B has roughly $1,120,000 (early gains grew the base before losses hit). The gap is $350,000 after just 5 years -- with identical average returns. Retiree A withdrew from a shrinking portfolio, locking in losses. Retiree B withdrew from a growing portfolio, preserving the compounding base. This is sequence-of-returns risk: the timing of returns relative to withdrawals matters more than the returns themselves.

Sequence-of-returns risk (SOR risk) is formally defined as the risk that the order of investment returns causes a worse outcome than the average return would suggest, specifically when combined with periodic withdrawals or contributions. During accumulation (when you are adding money), bad early returns actually help (you buy cheap shares -- dollar-cost averaging works in your favor). But during decumulation (when you are withdrawing), bad early returns are devastating because you are selling shares at depressed prices to fund withdrawals, permanently reducing the portfolio's ability to recover. Michael Kitces calls the first 5-10 years of retirement the 'retirement red zone' because adverse returns during this period have an outsized and irreversible impact on portfolio longevity. The mathematical mechanism: a portfolio declining 30% requires a 43% gain to recover. But if you are also withdrawing during the decline, you need even more -- potentially 60-80% recovery -- to get back to baseline.