Investor Corner/Building and judging a portfolio/Portfolio Construction & Behaviour
3.1.10 Sequence of Returns Risk
Sequence of returns risk describes how the specific order of investment returns, not just their long-run average, can dramatically affect an outcome, particularly for anyone actively withdrawing money near or during retirement.
Why order matters, not just the average
Two portfolios can experience the exact same set of annual returns over twenty years, just in a different order, and end up in meaningfully different places if withdrawals are being made along the way. Poor returns that happen to arrive early in the withdrawal period force selling more units at depressed prices, permanently reducing the capital base available to recover when returns eventually improve.
Sequence-of-returns risk is the danger that poor investment returns early in a withdrawal phase (typically retirement) will permanently damage the portfolio's ability to sustain withdrawals, even if average returns over the full period are adequate. Two retirees can experience the same average annual return over 25 years and end up with radically different outcomes depending on whether the bad years fell at the beginning or the end of their retirement.
During the accumulation phase, poor early returns are actually helpful if you are investing regularly through SIPs, because you are buying more units at lower prices. But during the withdrawal phase, the effect reverses: withdrawals from a declining portfolio deplete the unit count faster than the subsequent recovery can replenish. Once units are sold and the money is withdrawn, those units cannot benefit from the eventual market recovery. This is why the first 5-7 years of retirement are the most critical for portfolio sustainability.
Why this mainly affects the withdrawal phase
During the accumulation phase, when money is only being added and not withdrawn, the specific order of returns matters far less; a bad early year followed by strong later years still ends in roughly the same place as the reverse order, because no units were being sold into that early weakness. Once regular withdrawals begin, order suddenly matters a great deal, because withdrawals during a downturn lock in losses on the units sold.
Consider a retiree with ₹2 crore who withdraws ₹1 lakh per month (6% annual withdrawal rate). If markets fall 30% in year 1, the portfolio drops to ₹1.4 crore before any withdrawals. After 12 months of ₹1 lakh withdrawals, it is down to roughly ₹1.28 crore. Even if markets subsequently return 15% for several years, the portfolio may never fully recover because the withdrawals continue depleting the reduced base. If the same 30% drop happened in year 15 instead of year 1, the portfolio would have grown sufficiently in the intervening years to absorb the shock without compromising sustainability. Same average return, same total withdrawal, radically different outcome based purely on sequence.
Practical ways to manage it
Common approaches include holding a cash or short duration debt buffer covering a couple of years of withdrawals, so equity holdings are not forced to be sold during a downturn, and reducing the withdrawal rate temporarily during a market decline rather than withdrawing a fixed amount regardless of market conditions.
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The primary mitigation is to hold 2-3 years of expenses in low-volatility instruments (liquid funds, short-duration debt) at the start of retirement, so that equity drawdowns do not force sales at depressed prices. The equity portion continues compounding and is periodically rebalanced into the withdrawal buffer as markets permit. This "bucket strategy" ensures that the retiree never sells equity at the worst possible time, which is the exact mechanism through which sequence risk destroys portfolios.