How would you answer this question: If two investors each earn an average annual return of 7% over 20 years, do they end up in the same place?
When we ask clients what they think, most everyone assumes the answer is yes. But the math tells a different story. Two portfolios can have the same simple average yearly return—calculated by adding the annual returns and dividing by the number of years—yet produce very different outcomes depending on the order in which those returns occur, especially when you’re withdrawing money along the way.
When gains and losses occur can matter just as much as how much a portfolio gains or loses. In the world of investing, we call this phenomenon ‘sequence of returns risk,’ and it’s something we consider carefully when building investment strategies to support each client’s long-term financial goals.
One of my favorite Warren Buffett quotes is this: “Only when the tide goes out do you discover who’s been swimming naked.” Sequence risk illustrates his point. It can go unnoticed during favorable markets, only to become painfully apparent when a downturn coincides with the need to draw income from a portfolio.
A July article in The Street featured an alarming headline: “Vanguard sends wake-up call to every retiree.” As usual, there’s more nuance to the story (headlines get clicks, after all). The key message is that Vanguard projects a decade of US stock returns that could look quite different from those investors have enjoyed in recent years—a possibility with important implications for retirees drawing income from their portfolios.
To be clear, at LCM, we’re not in the business of reacting to market predictions, including Vanguard’s. Ten-year projections are, at best, educated guesses. But the article underscores an important point: retirement and distribution plans are sometimes built around the assumption that the future will resemble the recent past. When that assumption is tested by lower returns or an unexpected downturn, the most resilient plans are those that have accounted for these possibilities from the start.
The math behind the curtain
Let’s return to the original question. Imagine two investors, each starting with $5 million and each earning an average annual return of 7% over 20 years. Investor A experiences stronger returns in the early years and weaker returns later. Investor B experiences the exact same annual returns, but in reverse order, with the difficult years coming first. Without contributions or withdrawals, their ending balances would likely be quite similar. But when withdrawals enter the picture, everything changes.
Investor A, who benefits from strong early returns, has an opportunity to build a cushion before the difficult years arrive.
Investor B, who experiences losses early while simultaneously withdrawing funds, may struggle to recover.
That’s because withdrawing money from a declining portfolio means selling more assets to generate the same amount of income, leaving less capital invested to participate in a subsequent recovery. Despite identical long-term average returns, their ending balances can be very different. That’s sequence of returns risk in a nutshell.
It’s not just retirees
Most discussions of sequence of returns risk focus on retirees, and understandably so. But the same principle applies to any pool of capital that must support ongoing distributions.
Consider a business owner who sells a company, invests the proceeds, and relies on the portfolio to replace a salary. Or a trust established to provide a beneficiary with annual distributions. In either case, financial obligations continue regardless of market conditions. Poor returns early in the distribution period can have lasting consequences, even if subsequent years deliver strong performance.
The same holds true for the charitable foundations we work with and other organizations that depend on investment portfolios to fund their missions. A poorly timed market downturn can affect the portfolio’s long-term value and, ultimately, its ability to sustain the distributions that support important work.
Building resilience into the plan
This is why our approach to portfolio construction extends beyond targeting an attractive long-term return. We believe investing wisely means preparing for a range of possible outcomes rather than relying on any single market forecast.
For individuals and organizations that depend on regular distributions, that includes:
Maintaining appropriate cash and short-term reserves to help meet near-term needs without being forced to sell long-term investments during market declines.
Establishing disciplined withdrawal strategies that balance current income needs with the portfolio’s ability to sustain distributions over time.
Diversifying thoughtfully across asset classes to help manage risk and reduce dependence on the performance of any single segment of the market.
Stress-testing financial plans against challenging but plausible market scenarios rather than assuming that historical average returns will arrive predictably.
No strategy can eliminate sequence risk or guarantee that a portfolio will withstand every market environment. Together, however, these measures can provide greater flexibility and resilience during difficult periods.
Importantly, none of this requires predicting when the next downturn will occur. It simply requires recognizing that downturns are an inevitable part of investing and preparing accordingly.
Keeping the focus on what matters
At LCM, we believe the purpose of thoughtful investment management is not only to accumulate wealth. It’s to help clients use that wealth to live abundantly, care for the people they love, and give purposefully to the causes and communities that matter to them. Achieving those goals requires a disciplined strategy that considers how wealth will be used, when it will be needed, and how it can be sustained through inevitable market cycles.
We can’t control the order in which good and difficult market years arrive. But we can prepare for both, building investment and distribution strategies that help our clients make the most of their wealth without allowing short-term market conditions to dictate long-term decisions. Ultimately, that’s our goal: to give you the confidence to enjoy what you’ve built, provide for the people you love, and make a meaningful difference in the world around you.
