Glossary · UK
What is Sequence of Returns Risk?
The risk that the specific order in which investment gains and losses occur -- not just their average -- can significantly affect outcomes for someone withdrawing money regularly, such as in retirement.
Full Definition
Sequence of returns risk is the risk that the specific order in which investment gains and losses occur, rather than just their average over time, materially affects the final outcome for an investor who is regularly adding to or, especially, withdrawing from their investments, such as someone in pension drawdown taking a regular income from an invested pot. Two portfolios can experience exactly the same average annual return over a period but end up worth very different amounts if the pattern of good and bad years differs: a retiree who experiences poor investment returns in the first few years of drawdown, while still withdrawing a regular income, is forced to sell a larger proportion of their remaining pot at depressed prices to fund that income, permanently reducing the amount left to benefit from any later recovery, compared with someone who experiences the same poor returns later in retirement, or in the accumulation phase before withdrawals begin, when there is more time (or no ongoing withdrawals) to recover. This asymmetry is why sequence of returns risk is considered most dangerous in the years immediately before and immediately after retirement -- sometimes called the "retirement risk zone" -- since a market downturn during accumulation, with no withdrawals being taken, mainly affects the timing of eventual recovery, whereas the same downturn during early drawdown can permanently reduce how long a pension pot lasts, regardless of how well markets subsequently perform. Common ways of managing sequence of returns risk include holding one to three years of planned withdrawals in cash or lower-risk assets so that a market downturn does not force the sale of growth assets at depressed prices, reducing withdrawals temporarily during a downturn rather than taking a fixed amount regardless of market conditions, and using cash flow modelling to stress-test a drawdown strategy against a range of possible return sequences rather than a single average assumption.