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Sequence of Returns: Why the Order of Years Matters More Than the Average
Key takeaways
- Sequence-of-returns risk: poor returns at the start of retirement damage the portfolio more than the same returns at the end.
- An average return of 7% per year does not guarantee the portfolio's survival — the order matters.
- During the accumulation phase, sequence risk works in your favour: cheaper purchases during downturns.
- Protection: a cash cushion, bucket strategy, dynamic withdrawals.
- This risk is one of the reasons why 4% is not a guarantee.
Sequence-of-returns risk is the danger that poor returns arrive right at the start of the drawdown phase — and damage the portfolio irreparably, even if the average return over the whole period looks good. It is one of the least intuitive phenomena in investing.
Why the Order Matters
Imagine two situations: in both you have 10 million CZK, and in both the average return is 6% per year over 20 years. In the first scenario the first three years deliver −30% followed by strong growth. In the second, the opposite — first growth, then the downturn near the end. During accumulation it makes no difference. In the drawdown phase the difference is dramatic: in the first scenario you are selling cheap shares during the downturn, the portfolio shrinks faster, and the later growth cannot catch up.
Accumulation Phase vs. Drawdown Phase
In the accumulation phase, sequence risk is paradoxically favourable. When the market falls, you buy more cheaply and the average cost of your shares is lower — see DCA and cost averaging. A downturn doesn't hurt you if you're not withdrawing. In the drawdown phase it is exactly the opposite: you sell regardless of market conditions, and a downturn increases the number of shares sold.
How to Protect Yourself
There is no perfect protection, but there are strategies that help:
- Cash cushion: 1–2 years of expenses in cash or short-term bonds. During a downturn you draw from here and don't have to sell equities.
- Bucket strategy: you divide the portfolio into buckets covering 0–2 years, 3–10 years, and 10+ years. Each has different assets and a different horizon.
- Dynamic withdrawals: a bit more in good years, a bit less in bad ones. Even a 10% reduction in withdrawals during a downturn significantly extends the portfolio's lifespan.
Practical Conclusion
Sequence-of-returns risk is one of the main reasons why planning for retirement income is more complex than accumulating for it. You will understand it better by reading the article on calculating your path to retirement income and trying the projection under a pessimistic scenario.
FAQ
What is sequence-of-returns risk in simple terms?
It is the risk that the market falls right after you start withdrawing — at the worst possible time. You sell cheap shares, the portfolio shrinks quickly, and later growth cannot catch up. It's the order of returns that matters, not just the average.
How significant is the impact of sequence risk?
It can be fatal. Two investors with the same average return rate and the same withdrawals can have portfolios differing by millions of crowns after 20 years, depending on whether bad years came at the start or the end.
Does DCA (cost averaging) help during retirement?
No — DCA helps in the accumulation phase where you buy regularly. In the drawdown phase you sell regularly. Sequence risk during retirement is therefore not mitigated by DCA; you need different tools — a cash cushion or dynamic withdrawals.
How large a cash cushion should I have?
Generally 1–2 years of expenses in cash or short-term bonds is recommended. This gives you time to weather a downturn without needing to sell equities. Too large a cushion unnecessarily reduces the overall portfolio return.