📈  Chart of the Week 2/23/2025

By Michael Allison, CFA

A couple of weeks ago, we looked at the “Merciless Math of Losses” and the importance of investors lowering the risk in their portfolios as they approach retirement age. We also introduced the retirement-related concept of Sequence of Returns Risk.

This week, let’s delve a bit deeper into that concept.

Sequence of returns risk is one of the biggest hidden dangers retirees face. It’s not just about how much your portfolio earns on average over time—it’s about when you earn those returns. Get hit with a market downturn early in retirement while making withdrawals, and your portfolio might never recover.

The first Chart this week introduces two hypothetical investors: Mr. Green and Mr. Brown. Both start with $1 million at age 65, both experience an average annual return of 6%, and both end up with the same amount at age 90—as long as they aren’t taking withdrawals.

Notice that their returns happen in reverse order. Mr. Green experiences strong early returns, while Mr. Brown faces losses upfront. But since no withdrawals are happening, the sequence of those returns doesn’t matter.

This week’s second Chart introduces withdrawals into the equation. Both investors begin withdrawing 5% annually ($50,000) from their portfolios. This is where sequence risk kicks in.

Mr. Green starts in an up market. His portfolio grows early, giving him a strong base to withstand future downturns. At 90, he still has over $2.5 million left.

Mr. Brown isn’t so lucky. He starts with a rough market and is forced to withdraw from a shrinking portfolio. The result? His portfolio is depleted by age 83.

Why does this matter?

Averages can be misleading. Two investors can have the same average return, but if an investor gets hit with losses early while making withdrawals, they may never recover.

For retired investors, this means a few things:

1. Market Timing Matters (Even If You Can’t Control It). If an investor retires into a bull market, great. If they don’t? They need a plan.

2. A Flexible Withdrawal Strategy Is Key. Mr. Brown could have extended the life of his portfolio by reducing withdrawals during downturns. Retirees should consider dynamic spending strategies instead of fixed withdrawals.

3. Diversification and Risk Management Help. Having a diversified mix of assets can soften the impact of early losses. A well-structured portfolio isn’t just about maximizing return; it’s about minimizing damage when markets turn against you.

4. Cash Reserves Can Buy Time. Holding 1-2 years’ worth of living expenses in cash can prevent the need to sell investments in a downturn.

The Bottom Line

Sequence of returns risk isn’t about what your average portfolio returns are over time—it’s about how those returns are distributed over time. Retiring into a bear market without a strategy can be financially devastating.

The good news? With smart planning, flexibility, and a risk-aware approach, retired investors can avoid ending up like Mr. Brown.

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