Sequence-of-returns risk
Sequence-of-returns risk is the risk that the order of investment gains and losses changes the outcome when money enters or leaves a portfolio. Renditereihenfolge-Risiko (sequence-of-returns risk) matters most around retirement: two portfolios can experience the same returns, but the one hit by early losses while funding withdrawals can finish with much less money [1][2].
Why the order starts to matter
Without cash flows, multiplication is indifferent to order. A portfolio exposed to returns of -20%, +10%, and +20% ends at the same value whether the loss comes first or last: €100,000 x 0.80 x 1.10 x 1.20 = €105,600.
Withdrawals break that symmetry. A loss reduces the portfolio, and a withdrawal then removes capital that can no longer participate in a later recovery. An early gain creates the opposite effect: later withdrawals come from a larger base. The average return alone therefore cannot describe a decumulating portfolio.
This risk is different from ordinary volatility. Volatility describes how widely returns move. Sequence risk describes the damage caused when those moves arrive at an inconvenient time relative to contributions or withdrawals. Research on retirement savings identifies the start of decumulation as a particularly sensitive period [1][2].
Worked example
Two retirees each start with €100,000 and withdraw €10,000 at the beginning of every year. Both portfolios experience exactly the same three annual returns, but in reverse order. Taxes, fees, and inflation are omitted to isolate the sequence effect.
| Year | Early-loss return | Early-loss balance | Early-gain return | Early-gain balance |
|---|---|---|---|---|
| Start | — | €100,000 | — | €100,000 |
| 1 | -20% | (€100,000 - €10,000) x 0.80 = €72,000 | +20% | (€100,000 - €10,000) x 1.20 = €108,000 |
| 2 | +10% | (€72,000 - €10,000) x 1.10 = €68,200 | +10% | (€108,000 - €10,000) x 1.10 = €107,800 |
| 3 | +20% | (€68,200 - €10,000) x 1.20 = €69,840 | -20% | (€107,800 - €10,000) x 0.80 = €78,240 |
Both retirees withdrew €30,000 and received the same set of returns. The early-loss portfolio ends with €69,840; the early-gain portfolio ends with €78,240 — a difference of €8,400 created only by timing.
What determines the exposure
Sequence risk is a planning constraint, not a forecast of the next market crash. Its effect depends on four variables:
| Variable | More exposed when | Less exposed when |
|---|---|---|
| Withdrawal need | A large share of spending must come from the portfolio | Predictable income covers more of the spending floor |
| Spending flexibility | Withdrawals cannot adjust after losses | Some discretionary spending can move between years |
| Near-term assets | Near-term withdrawals require selling volatile assets | Near-term spending is not fully dependent on current market prices |
| Time horizon | The portfolio must fund a long retirement | The required funding period is shorter or partly covered elsewhere |
The framework is to test a retirement plan under bad early returns, not only under a smooth average. Possible responses include changing the asset mix, holding a liquid spending reserve, varying withdrawals, or covering part of essential spending with lifetime income. Each response trades expected return, flexibility, liquidity, or guarantees against resilience; none removes every risk [3].
Check yourself
Two retirees start with equal portfolios, make equal withdrawals, and experience the same set of annual returns. Why can they finish with different balances?
A portfolio starts at €100,000, pays a €10,000 withdrawal at the beginning of the year, and then loses 20%. What is its year-end balance, in euros?
A portfolio has no contributions or withdrawals. It experiences returns of -20%, +10%, and +20%. What happens if those returns occur in reverse order?
Which change most directly reduces a household's exposure to sequence-of-returns risk during retirement?
Sources
- Clare, A., Glover, S., Seaton, J., Smith, P. N. and Thomas, S. — Measuring sequence of returns risk, Journal of Retirement, https://openaccess.city.ac.uk/id/eprint/25138/ (2020)
- Sołdek, A. and Stachnio, M. — Sequence-of-returns risk in the management of retirement savings, Rozprawy Ubezpieczeniowe — Konsument na rynku usług finansowych, 28(2), pp. 22–38, https://open.icm.edu.pl/handle/123456789/15933 (2018)
- OECD — Designing the payout phase for defined contribution pensions to better meet financial needs in retirement, https://www.oecd.org/en/publications/oecd-pensions-outlook-2024_51510909-en/full-report/component-8.html (2024)