Sequence Risk
Why the order of returns doesn't matter for money left alone, matters a great deal for money being withdrawn, and works in the opposite direction for someone still saving.
The short version
If you invest a lump sum and leave it alone, the order of good and bad years makes no difference to where you end up. Once money is going in or out, order matters. For someone withdrawing money, bad years early do lasting damage, because withdrawals lock in losses. For someone saving, bad years early actually help, because new money buys in cheaply. This is sequence risk, and it's why portfolios usually become more cautious as withdrawals approach.
By the end of this lesson, you'll be able to
- Show that return order doesn't matter for a lump sum left untouched
- Explain why early losses hurt someone making withdrawals
- Describe common ways to reduce sequence risk
Why this matters
This optional lesson matters most to people who are, or will be, living off their investments, such as retirees. But it's worth understanding early, because it explains why portfolios usually shift toward bonds and cash as a goal approaches, and why the same bad year can be harmless to one investor and serious for another.
When order doesn't matter
Take five years of hypothetical returns: +20%, +15%, +10%, −10%, and −20%. The average is +3%. If you invest $500,000 and leave it alone, the order makes no difference: multiplication works in any order, so 1.20 × 1.15 × 1.10 × 0.90 × 0.80 gives the same result as the reverse. Either way, you'd end with $546,480.
When order matters: taking money out
Now suppose you withdraw $40,000 at the end of each year, as a retiree might.
| End of year | Good years first | Bad years first |
|---|---|---|
| 1 | $560,000 (+20%) | $360,000 (−20%) |
| 2 | $604,000 (+15%) | $284,000 (−10%) |
| 3 | $624,400 (+10%) | $272,400 (+10%) |
| 4 | $521,960 (−10%) | $273,260 (+15%) |
| 5 | $377,568 (−20%) | $287,912 (+20%) |
Same five returns, same withdrawals, same average. The bad-years-first retiree ends with about $90,000 less. Their withdrawals in the early years came out of a shrunken portfolio, selling more of it at low prices, and that money wasn't there for the recovery. All figures are hypothetical.
This is Sequence risk. The risk that bad returns arrive at the wrong time, especially early in a period of regular withdrawals, doing lasting damage. Glossary: the risk that poor returns arrive at the wrong moment. It's most dangerous in the years just before and just after withdrawals begin, when the portfolio is at its largest and has the least time to recover.
The rest of this lesson is for members
Still to come in this lesson: The opposite for savers, Common ways to reduce sequence risk, the key takeaways, and 2 quiz questions with explanations.
Membership opens every lesson in the curriculum, the capstone projects, the interactive tools, and the members-only channels in the Hyperion Entities Discord. The first lesson of every module stays free.
Go deeper
- Sequence Risk in Depth coming soonInvesting Through Retirement (depth track)
- Withdrawal Rates and Withdrawal Strategies coming soonInvesting Through Retirement (depth track)
- Target-Date FundsPart 2: What You Can Own