Definition
Sequence of returns risk is the statistical phenomenon where the order of investment returns significantly impacts portfolio longevity during decumulation, even when the arithmetic mean return is identical.
Path Dependency: During accumulation, return order is irrelevant to final value (multiplication is commutative). During decumulation with withdrawals, early losses permanently reduce the capital base available for recovery.
Think of it as reverse dollar-cost averaging. When accumulating, you buy more shares when prices are low (good). When decumulating, you sell more shares when prices are low (bad). This asymmetry makes early retirement years uniquely vulnerable.
Mathematical Demonstration
Consider two portfolios with identical arithmetic mean returns but opposite sequences:
Initial: $1,000,000 | Annual Withdrawal: $50,000 | Mean Return: 5%/year
Δ = $479,000 | Same 5% arithmetic mean
Where negative r(t) early amplifies W(t) impact on future V(t)
Why Accumulators Are Immune: If you're still working and contributing, a market crash is actually helpful — you're buying cheap. Your human capital (future earnings) acts like a bond, providing stability. Sequence risk only emerges when you stop contributing and start withdrawing.
Risk Window Analysis
Sequence risk is asymmetrically distributed across the retirement timeline:
Maximum vulnerability occurs in the first 5-10 years of decumulation.
Mitigation Strategies
Buffer Strategy: Maintain 2-3 years of expenses in cash/short-term bonds. Withdraw from buffer during drawdowns, allowing equity positions to recover without forced selling.
- Cash buffer (2-3 years): Avoid selling equities at depressed prices
- Dynamic withdrawal: Reduce spending 10-20% when portfolio drops 20%+
- Rising equity glide path: Start conservative, increase equity allocation over time
- Guaranteed income floor: Social Security, pensions, or SPIAs for baseline expenses
Monte Carlo Insight: The P10 outcome in Chubby simulations often represents scenarios with adverse early-sequence returns. Stress testing with explicit year-1 shocks isolates this risk factor.