Sequence-of-Returns Risk: The Retirement Danger That Has Nothing to Do With Average Returns

Many investors like to think that the stock market returns about 7 to 8% a year over the long run, and for S&P500, that number was about 10%.  That sounds reassuring, and it is often used as the basis for retirement planning.  But these averages can hide an important problem.  Two investors can experience exactly the same average return over 30 years and still end up in very different financial positions, simply because the good and bad years happened in a different order.  That is sequence-of-returns risk, or SRR.

What Sequence-of-Returns Risk Actually Is

Sequence-of-returns risk is the risk that the order in which investment returns happen matters, especially when you are withdrawing money from your portfolio.  Imagine two retirees who start with the same portfolio, withdraw the same amount every year and experience exactly the same set of returns over 25 years, just in reverse order.

• Retiree A experiences a major crash in year 1, followed by a long recovery.

• Retiree B experiences the same crash in year 25.

Their average annual return is identical, but their outcomes are not.  Retiree A is withdrawing from a portfolio that has just fallen.  To raise the same amount of cash, more shares have to be sold, leaving fewer shares to participate in the recovery.  Retiree B has had years of compounding before the crash arrives, so the same decline happens to a much larger portfolio and there is little time left for it to affect the overall retirement outcome.

The simple version is:  A loss becomes much more damaging when you are forced to sell during it.

That is what makes SRR different from ordinary market volatility.  If I am still working and accumulating, I can sit through a market downturn without selling.  I may even be buying more shares at lower prices.  Once I am retired and withdrawing from the portfolio, the same downturn becomes much more dangerous.

How It Shapes an Investor's Journey to Retirement

SRR matters most around the transition into retirement.  During accumulation, it is largely a non-issue. I am still earning, contributing and buying investments.  A market crash is painful to watch, but I have time for the portfolio to recover.  At retirement, the situation changes.  The portfolio is no longer just something I am building.  It is now something I am depending on to pay my bills.  This is why the first 5 to 10 years of retirement are often called the "retirement red zone".  A major downturn combined with withdrawals can do far more damage than the same downturn much later.

Later in retirement, SRR gradually becomes less important, assuming the portfolio has survived the early years.  The portfolio has had more time to compound and there are fewer years of withdrawals remaining.  This is also why safe withdrawal rate studies are concerned with more than average returns.  The question is not simply how much a portfolio earns over the long run, but whether it can survive a particularly bad sequence of returns while withdrawals continue.

Pros, Cons, and Risks

The biggest risk is straightforward: Forced selling at depressed prices.

Once shares are sold, they no longer participate in the recovery.  There are other problems too.  SRR is largely outside our control, it can become worse when combined with high inflation, and a portfolio that looks perfectly sustainable based on average returns can still fail if the early years are particularly bad.  But understanding SRR also gives us ways to manage it.

We can hold cash or bonds amounting to several years of expenses, reduce spending during bad markets, adjust our withdrawal rate, change our asset allocation, or build enough passive income that we do not need to sell investments in the first place.  The important point is that SRR is not something I can solve simply by finding better investments.  It is a problem created by withdrawing from investments at the wrong time.

How This Plays Out for a Singapore Dividend Investor

This is where things get more interesting for me as a dividend investor.  Dividend investing can naturally reduce SRR because I am not relying on selling shares to generate my spending money.  If my portfolio falls 30% but I do not sell anything, I still own the same number of shares.  The problem is that dividends are not guaranteed either.  Instead of the share price forcing me to sell, a dividend cut can create the same problem from another direction.

Singapore gave us a good example in 2020.  During the COVID-19 pandemic, the Monetary Authority of Singapore directed DBS, OCBC and UOB to cap their FY2020 dividends per share at 60% of FY2019 levels as a precautionary measure to preserve capital.  For an investor heavily dependent on Singapore's three banks for dividend income, that was a very significant income shock, and it happened during a major market and economic downturn.

The dividends subsequently recovered as conditions improved.  But for someone living on those dividends in 2020, the problem was immediate.  The bills still had to be paid.  This is why I do not think a dividend investor can simply think that since I do not sell my shares, so sequence-of-returns risk does not apply to me.  It is more accurate to say that dividend investing can avoid the forced-selling part of SRR, provided the dividends are sufficient.

What Actually Closes the Gap For Me?

For me, there are two things that make dividend investing much more useful as a defence against SRR.  First, dividend income should have a buffer over expenses.  If my expenses are $40,000 and my dividends are exactly $40,000, a dividend cut immediately creates a problem.  If my dividends are $50,000 or $60,000, I have much more room to absorb a cut.

Second, I need a fallback.  That could be cash set aside, flexible spending habits or supplementary income.  The objective is I do not want a bad year to force me to sell shares.  Without these two conditions, a dividend investor has not really escaped the problem.  The risk has simply changed form.  Instead of a falling share price forcing me to sell, dividend cuts may eventually force me to do the same thing.

The Bottom Line

Sequence-of-returns risk is a reminder that the period when something happens can matter just as much as what happens on average.  During accumulation, a market crash is mostly an opportunity to keep buying.  But during retirement, the same crash can be dangerous if I need to sell investments to fund my lifestyle.  For a dividend investor, I can potentially fund my expenses without selling shares, but dividend cuts can still create a shortfall.

So I do not think that dividend investing eliminates sequence-of-returns risk.  Instead, dividend investing can remove the need to sell shares, but only if the dividends are sufficient and I have a backup plan for the years when dividends are insufficient.  Barista FIRE, here I come...!