Why the order matters
An average return is not what you earned. A portfolio that gains 40% and then loses 30% averages 5% a year, but it is actually down 2%. The wider the swings, the further the average drifts from reality. Start withdrawing, and the order of those returns decides whether the money lasts.
Same returns. Same 9.5% average. Only the order changes.
Average return
9.0%
What it actually earned
9.00%
After 20 years
$2,279,245
Average return
9.5%
What it actually earned
7.77%
Money ran out
Year 10
The portfolio with the higher average return ran out of money in year 10. The steady one still has $2,279,245.
Why it happens
This one applies whether or not you are withdrawing. A bumpy path compounds to less than a smooth one with the same average, because a loss needs a bigger gain to undo it. Lose 50% and you need 100% just to get back to even.
In the illustration above, switch to while you are still working and you can see it on its own: the higher-average portfolio still finishes behind.
This one only shows up once you are taking money out. Selling shares during a downturn to fund your income means those shares are gone — they are not there when the market recovers.
That is why moving the downturn later changes the outcome by more than a million dollars, even though the returns and their average never change.
What to do about it
Questions
Sequence-of-returns risk is the danger that poor returns early in retirement, combined with withdrawals, permanently damage a portfolio. The same set of returns in a different order can mean running out of money or finishing with plenty. It matters most in the first five to ten years, when the balance is largest.
Because an average is not what you earn. A portfolio that gains 40% then loses 30% averages 5% a year but is actually down 2%. The wider the swings, the further the average drifts from what compounded. Add withdrawals and the gap widens again.
The 4% rule was a useful research finding, not a plan. It assumes a fixed portfolio, fixed spending, and a 30-year retirement, and it says nothing about which years the bad returns land in. It can work. It can also fail badly if your first five years are poor.
You can't eliminate all risk, but you can reduce it. One of the many advantages of the Next Phase strategy is that it lowers this risk so you have a greater chance for success.
That is what the first conversation is. Thirty minutes, and you will leave knowing whether your plan accounts for this.
