Two Retirees, Same Average Return, Very Different Endings: This Is Sequence of Returns Risk
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5 min read
Imagine two retirees. Both start with Rp1 miliar. Both earn the exact same average return over the next three years, 5% a year. Both withdraw the same amount every year to live on. One of them ends up with almost Rp70 million more than the other, purely because of the order the good and bad years arrived in. This is called sequence of returns risk, and it matters more than most people realize.
Sequence of returns risk is the danger that the order of your investment returns, not just their average, can determine whether your money lasts. It only shows up when money is moving in or out of a portfolio on a regular basis, most obviously withdrawals in retirement. As financial planning researcher Michael Kitces puts it, "even if markets average out to long-term returns eventually, if early returns are too low for too long, ongoing withdrawals can deplete the portfolio before the good returns finally arrive." A portfolio that is never touched does not carry this risk at all. It is entirely about what happens when you are pulling money out while the balance is still moving.
The reason it concentrates so heavily in the first years of withdrawal is simple: that is when the portfolio is at its largest, so a bad year does the most absolute damage. A bad year ten or twenty years into retirement hits a smaller, already-shrunk balance, and does less harm in rupiah terms even if the percentage loss is identical.
Indonesia's own market history has a real version of this. IHSG fell roughly 50.6% over the course of 2008, as global capital fled emerging markets during the financial crisis. The very next year, 2009, IHSG rose about 87%, one of the sharpest one-year recoveries in the index's history.
Picture someone who retired at the end of 2007 and started withdrawing a fixed amount from an IHSG-heavy portfolio at the start of 2008. Every withdrawal that year came out of a balance that was actively collapsing, which means more units had to be sold to raise the same amount of cash, leaving fewer units left over to benefit when the 87% rebound arrived in 2009. Someone who retired two years later, in 2010, faced the same long-run average return over the following decade, but never had to fund withdrawals directly out of the worst single year in the index's recent history. Same market, same long-run average, very different starting experience.
Here is the mechanism in its cleanest form, an illustrative hypothetical, not a real portfolio. Two retirees each start with Rp1,000,000,000 and withdraw Rp60,000,000 at the start of each year for three years. Both experience exactly the same three annual returns, -25%, +10% and +30%, average 5% a year either way. Retiree A gets them in that order. Retiree B gets the same three numbers in reverse.
| Year | Retiree A's return | Retiree A's balance after withdrawal and return | Retiree B's return | Retiree B's balance after withdrawal and return |
|---|---|---|---|---|
| 1 | -25% | Rp705,000,000 | +30% | Rp1,222,000,000 |
| 2 | +10% | Rp709,500,000 | +10% | Rp1,278,200,000 |
| 3 | +30% | Rp844,350,000 | -25% | Rp913,650,000 |
Retiree B ends up with Rp913,650,000, about Rp69,300,000 more than Retiree A's Rp844,350,000, from the identical three returns, the identical withdrawals, and the identical 5% average. The only variable that changed was which year the -25% landed in.
This risk runs in the other direction for someone still contributing rather than withdrawing. Kitces notes plainly that sequence risk "does not apply if the portfolio has no withdrawals." If you are putting a fixed amount into your portfolio every month rather than taking money out, a bad year early on is not the threat it is for a retiree. A fixed rupiah contribution buys more units when prices are down, and those extra units are still sitting in the account when prices eventually recover. It is the same mechanism as the table above, just running the opposite way because money is flowing in instead of out.
Nobody can predict which years will be the bad ones. What is within your control is how exposed your own plan is if a bad year happens to land early. A withdrawal amount that is fixed regardless of how the portfolio performed the year before is more exposed than one that flexes down after a bad year. A portfolio you periodically bring back to your intended rebalancing schedule also stops one bad asset class from dragging the whole balance down further than it should.
Check your own withdrawal amount and current allocation against your actual holdings on NetWort's Portfolio Health view, and see today's rate and market conditions on the Macro Context page before assuming next year will look like this one.