Historical Sequence of Returns Risk

Sequence of returns risk is one of the most underappreciated dangers in retirement planning. Two portfolios can experience identical average returns yet end up with dramatically different outcomes based solely on the order in which those returns occur. By stress testing your portfolio against actual historical return sequences, you can better understand how your plan might perform through real-world market conditions.

What Is Sequence of Returns Risk?

Sequence of returns risk refers to the danger that the timing of poor investment returns can permanently impair a portfolio, particularly when withdrawals are being made. This risk is most acute during two critical periods:

The Accumulation Phase (Final Years)

A market crash just before retirement can devastate decades of savings
Portfolio value at retirement determines sustainable withdrawal amounts
Less time to recover from losses
May force delayed retirement or reduced lifestyle

The Distribution Phase (Early Years)

Early retirement losses combined with withdrawals create a "double hit"
Selling assets at depressed prices locks in losses
Reduced portfolio cannot fully participate in recovery
Can lead to premature portfolio depletion

Why the Order of Returns Matters

The Mathematics of Sequence Risk

Consider two retirees with $1,000,000 portfolios, each withdrawing $50,000 annually. Both experience the same average return over 10 years, but in opposite order:

Retiree A: Poor returns early (-15%, -10%, -5%), then recovery
Retiree B: Strong returns early (+15%, +10%, +5%), then decline

Despite identical average returns, Retiree A may run out of money while Retiree B thrives. The difference? Retiree A sold assets at low prices to fund withdrawals, while Retiree B sold at high prices.

Why This Happens

Compound Growth: Early losses reduce the base for future compounding
Forced Selling: Withdrawals require selling regardless of market conditions
Recovery Math: A 50% loss requires a 100% gain to break even
Diminishing Base: Withdrawals from a declining portfolio accelerate depletion

Stress Testing with Historical Sequences

Rather than relying solely on average expected returns, stress testing runs your financial plan through actual historical market sequences. This approach answers a critical question: "Would my plan have survived the worst periods in market history?"

How It Works

Select Historical Period: Choose a specific starting year (e.g., 1929, 1966, 2000)
Apply Actual Returns: Run your plan using the exact sequence of returns that followed
Track Portfolio Health: Monitor how the portfolio responds to each year's actual market performance
Identify Breaking Points: Discover under what conditions your plan fails

Benefits Over Fixed Return Assumptions

Reality Check: Tests against actual market behavior, not theoretical averages
Captures Clustering: Bad years often cluster together (see 1929-1932, 2000-2002)
Includes Extremes: Incorporates crashes, recoveries, and everything in between
Psychological Preparation: Helps you understand what market stress actually looks like

Challenging Historical Periods

These periods represent the most severe stress tests for retirement portfolios:

The Great Depression (1929-1932)

Cumulative Loss: ~86% peak-to-trough decline
Duration: 4 years of consecutive losses
Recovery Time: 25 years to reach previous peak (nominal)
Key Lesson: Even severe crashes eventually recover, but timing matters

Stagflation Era (1966-1982)

Real Returns: Near zero after inflation adjustment
Duration: 16 years of sideways movement
Challenge: High inflation eroded purchasing power
Key Lesson: Nominal gains can mask real losses

Lost Decade (2000-2009)

Dot-Com Crash: 2000-2002 (~49% decline)
Financial Crisis: 2007-2009 (~57% decline)
Result: Negative total returns for the decade
Key Lesson: Two major crashes in one decade is possible

Other Notable Periods

1973-1974: Oil crisis, ~48% decline
1987: Black Monday, 22% single-day drop
2020: COVID crash, ~34% decline (rapid recovery)
2022: Simultaneous stock and bond losses

Actual Annual Returns (1928-2024)

The chart below shows actual S&P 500 annual returns over nearly a century. Notice the extreme variability—years of +40% gains followed by -40% losses. This volatility is what makes sequence risk so dangerous for those withdrawing from portfolios.

Portfolio Stress Test Results

This chart demonstrates the power of historical sequence stress testing. By running a portfolio through multiple historical periods, we can visualize the wide range of possible outcomes. The shaded areas show the minimum, mean, and maximum portfolio values across all tested sequences, while the lines highlight specific benchmarks.

Reading the Results

Worst Sequence (Red Area): What happens if you retire into a period like 1929 or 2000
5th Percentile (Red Line): The "bad luck" scenario—still a 1 in 20 chance of worse
Fixed Rate Assumption (Blue Line): Traditional planning with constant 7% returns
Median Outcome (Yellow Line): The "typical" experience across all sequences
Best Sequence (Green Area): Retiring into a bull market like 1982 or 2009

Key Observations

The spread between best and worst outcomes is enormous—millions of dollars
Fixed return assumptions can dramatically understate or overstate outcomes
The worst sequences often lead to portfolio depletion (notice the minimum reaching zero)
Most outcomes cluster closer to the median than the extremes

Protecting Against Sequence Risk

Flexible Withdrawal Strategies

Variable Withdrawals: Reduce spending in down markets
Guardrails: Set upper and lower bounds on withdrawal rates
Percentage of Portfolio: Withdrawals automatically adjust to portfolio size
Discretionary vs. Essential: Know what expenses can be cut if needed

Cash Buffer / Bond Tent

Cash Reserve: 1-3 years of expenses in cash or short bonds
Rising Equity Glidepath: Start conservative, increase stocks over time
Avoid Forced Selling: Don't sell stocks in a downturn
Psychological Benefit: Sleep better knowing you have a buffer

Diversification Strategies

Asset Class Diversification: Stocks, bonds, real estate, alternatives
Geographic Diversification: U.S. and international markets
Factor Diversification: Value, growth, size factors
Time Diversification: Dollar-cost averaging in and out

Income Sources

Social Security: Delay to maximize guaranteed income
Pensions: Valuable hedge against sequence risk
Annuities: Can provide baseline income floor
Part-Time Work: Reduces withdrawal needs in early retirement

Practical Applications

Running Your Own Stress Tests

Use financial planning tools that incorporate historical sequence testing
Test your plan against specific adverse periods (1966, 2000, 2007)
Ask: "Would my plan survive the worst 30-year period?"
Adjust withdrawal rates until your plan survives stress tests

Interpreting Results

100% Success Rate: May mean you're being too conservative
80-90% Success Rate: Generally considered acceptable
Below 80%: Consider reducing withdrawals or adjusting strategy
Focus on Flexibility: Plans with adjustment mechanisms are more robust

Limitations of Historical Stress Testing

Past ≠ Future: History doesn't predict future market behavior
Limited Samples: Only ~100 years of reliable data
Survivorship Bias: U.S. markets have been exceptionally successful
Black Swans: Future crises may be worse than any in history

Beyond Historical Testing

Combine with Monte Carlo analysis for probabilistic outcomes
Consider hypothetical "worse than history" scenarios
Build in margin of safety for unknown unknowns
Plan for flexibility rather than precision

Historical sequence of returns analysis provides a powerful reality check for retirement planning. By seeing how your portfolio would have performed through actual market conditions—including the Great Depression, stagflation, and the dot-com crash—you gain perspective that simple average return assumptions cannot provide.

The key takeaway: your retirement success depends not just on how much the market returns, but when those returns occur. By stress testing against historical sequences and building in appropriate safeguards, you can create a more resilient financial plan that can weather whatever sequence of returns the future brings.