Investment performance is often summarized with an average annual return, but Monty Cerf provides a useful point of reference for examining why averages do not always tell the complete story. Two portfolios can experience similar average returns over time and still produce very different outcomes depending on when gains and losses occur, particularly when money is regularly being withdrawn.

This concept is commonly known as sequence-of-returns risk. It becomes especially important when investors transition from accumulating wealth to drawing from it. A significant market decline early in a withdrawal period can create challenges that may not be fully repaired by strong returns later.

Average Returns Can Hide Important Differences

Average return is useful because it provides a convenient way to summarize investment performance.

However, an average does not show the order in which individual returns occurred.

Consider two hypothetical portfolios experiencing the same collection of annual gains and losses. One encounters its strongest years early and its weakest years later. The other experiences return in reverse order.

If no money enters or leaves either portfolio, the final results may be relatively similar.

Once regular withdrawals begin, the sequence can become much more important.

When money is removed during a market decline, more assets may need to be sold to generate the required amount of cash. Those assets are then unavailable to participate in a subsequent recovery.

Accumulation and Withdrawal Create Different Conditions

During the accumulation stage, investors are generally adding capital rather than removing it.

Market declines can still be uncomfortable, but someone making regular contributions may actually purchase additional investments at lower prices.

The situation changes once withdrawals begin.

Now the portfolio is being asked to perform two functions simultaneously:

• Support ongoing withdrawals
• Preserve enough capital for future needs

A major decline early in this period can place pressure on both objectives.

This is why a portfolio appropriate during wealth accumulation may need to be reconsidered when the purpose of the assets changes.

Timing Matters Most When Cash Is Leaving the Portfolio

Sequence risk becomes particularly relevant when withdrawals occur during volatile periods.

Imagine a portfolio experiencing a substantial decline.

If no withdrawal is required, the investor may be able to remain invested and wait for a potential recovery.

If money must be withdrawn, however, investments may need to be sold while their values are depressed.

That creates a mathematical challenge.

The remaining portfolio now has a smaller capital base from which to recover.

Even if markets eventually produce strong returns, those later gains apply to fewer invested assets.

Losses Early in a Withdrawal Period Can Be Particularly Difficult

A poor market year does not have the same impact at every point in an investment horizon.

A significant decline occurring many years after withdrawals begin may affect a portfolio that has already benefited from substantial growth.

The same decline occurring immediately after withdrawals begin can have a much larger long-term effect.

This makes the first several years of a withdrawal period particularly important from a risk-management perspective.

Investors cannot control when market declines occur.

They can, however, consider how the portfolio might respond if difficult markets arrive at an inconvenient time.

A Simple Example Shows Why Sequence Matters

Suppose two investors begin with identical portfolios and experience the same long-term average return.

Investor A experiences several strong years first, followed later by weaker markets.

Investor B experiences the same returns in reverse order, with substantial losses occurring near the beginning.

Without withdrawals, the order may have limited influence on the ending value.

With regular withdrawals, Investor B may experience a significantly different result.

Capital is being removed while asset values are already lower, leaving less invested when stronger markets eventually arrive.

The difference is not necessarily investment selection.

It is timing combined with cash flow.

Market Recovery Does Not Automatically Restore the Portfolio

A common assumption is that if markets recover after a decline, the portfolio will simply return to its previous position.

Withdrawals complicate that assumption.

Suppose investments decline and some assets are sold to fund expenses. When markets recover, only the assets still held participate in the rebound.

This means the portfolio can experience a permanent effect even when the market itself eventually reaches new highs.

Sequence risk therefore illustrates why portfolio management cannot focus exclusively on whether markets are expected to recover eventually.

The investor’s cash needs during the recovery period also matter.

Liquidity Can Provide Flexibility During Weak Markets

One approach to sequence risk involves maintaining sufficient liquidity.

If near-term spending needs can be met without immediately selling volatile assets, investors may have greater flexibility during a market decline.

Liquid resources might include cash or other relatively stable assets designated for shorter-term requirements.

The appropriate amount depends on individual circumstances.

Holding too much cash can create other challenges, including reduced long-term growth potential and exposure to inflation.

The objective is not to avoid investing.

It is to consider whether enough liquidity exists to prevent every financial need from depending on selling long-term assets at whatever price happens to be available.

Asset Allocation Becomes Especially Important

Sequence risk also reinforces the importance of asset allocation.

A portfolio concentrated heavily in volatile assets may have significant long-term growth potential while also being vulnerable to large short-term declines.

A more diversified allocation may include assets serving different purposes.

Some investments may provide growth potential. Others may contribute income, stability, diversification, or liquidity.

No allocation eliminates market risk.

The goal is to create a portfolio structure that reflects both long-term objectives and the possibility that withdrawals may occur during unfavorable markets.

Withdrawal Flexibility Can Affect Portfolio Resilience

Not every investor has completely fixed spending requirements.

Some expenses are essential, while others may be discretionary.

That distinction can create flexibility.

During particularly difficult market periods, reducing optional withdrawals may help limit the amount of capital removed from depressed assets.

This does not mean spending should automatically change whenever markets decline.

Rather, understanding which expenses are flexible can provide another tool for managing uncertainty.

A financial plan built around completely inflexible assumptions may be more vulnerable when actual market conditions differ from expectations.

A Fixed Withdrawal Percentage Can Behave Differently Over Time

Withdrawal strategies are sometimes expressed as a percentage of portfolio value.

However, the interaction between withdrawals and changing market values deserves careful attention.

A fixed dollar withdrawal represents a larger percentage of the portfolio after a significant decline.

For example, an annual withdrawal that initially represented a modest portion of assets may become considerably more demanding if portfolio value falls sharply.

This can accelerate depletion during weak markets.

Reviewing withdrawal levels periodically can therefore help determine whether spending remains aligned with the portfolio’s current capacity.

Inflation Adds Another Layer

Investors planning for long-term withdrawals also need to consider purchasing power.

Expenses rarely remain completely unchanged for decades.

Inflation can gradually increase the amount of money required to maintain a similar standard of living.

This creates an additional challenge during poor return sequences.

A portfolio may face declining asset values at the same time that required withdrawals are increasing.

The interaction among inflation, market performance, and withdrawals is one reason long-term planning should consider multiple scenarios rather than rely solely on a single average-return assumption.

Bonds and Other Defensive Assets Have Their Own Risks

Adding less volatile assets to a portfolio can help manage certain forms of risk, but no investment category is risk-free.

Bonds can be affected by:

• Interest-rate changes
• Inflation
• Credit risk
• Duration
• Market conditions

Cash can lose purchasing power over time.

The purpose of diversification is not to identify an asset that never declines.

It is to combine different sources of risk and return so that the portfolio does not depend entirely on one market environment.

Scenario Analysis Can Be More Useful Than a Single Forecast

Long-term financial projections often use assumed average returns.

While useful, a single assumption can create a false sense of precision.

Actual markets rarely deliver the same return every year.

Scenario analysis can provide a broader view.

Instead of asking only what happens if a portfolio earns a particular average return, investors might examine:

• What happens if markets decline early?
• What happens if inflation remains elevated?
• What if withdrawals increase unexpectedly?
• What if strong returns arrive later than expected?
• What if several weak years occur close together?

These scenarios do not predict the future.

They test whether a financial strategy remains workable under different conditions.

Risk Capacity Can Change When Withdrawals Begin

An investor may feel comfortable with substantial market volatility during the accumulation years.

That does not automatically mean the same level of risk remains appropriate once withdrawals begin.

The reason is not necessarily emotional.

The financial consequences have changed.

When capital is being accumulated, time and future contributions may provide opportunities to recover from losses.

When capital is being withdrawn, the portfolio has fewer ways to compensate for an unfavorable sequence.

Risk capacity should therefore be evaluated in relation to the purpose of the assets, not simply an investor’s willingness to tolerate market fluctuations.

Diversification Helps Reduce Dependence on One Outcome

A diversified portfolio cannot guarantee protection from sequence risk.

Broad market declines can affect many assets simultaneously.

However, diversification can reduce dependence on a single source of return.

Different assets may respond differently to changes in economic growth, inflation, interest rates, and market sentiment.

When some portions of a portfolio remain relatively resilient, investors may have more options for meeting cash needs without selling assets that have experienced the largest declines.

That flexibility can become particularly valuable during uncertain periods.

Portfolio Reviews Should Consider Cash Flow, Not Just Performance

Investment reviews frequently focus on which holdings performed best or worst.

For investors making withdrawals, cash flow deserves equal attention.

A useful review might examine:

• Upcoming spending needs
• Available liquid assets
• Current withdrawal rate
• Asset allocation
• Portfolio concentration
• Changes in inflation
• Changes in financial objectives

The purpose is to understand whether the portfolio remains capable of supporting its intended role.

Strong recent returns do not necessarily mean withdrawals can increase indefinitely, just as a temporary decline does not automatically require abandoning a long-term strategy.

Avoiding Sequence Risk Entirely Is Not Realistic

There is no reliable way to ensure that favorable market returns occur at the most convenient time.

Attempting to predict exactly when a major decline will happen creates its own risks.

An investor who becomes excessively defensive while waiting for a downturn may miss substantial market appreciation.

Sequence risk is therefore primarily a planning problem rather than a forecasting problem.

The objective is to create enough resilience that the portfolio does not depend on markets following one particular path.

Flexibility Can Be More Valuable Than Precision

Long-term financial planning naturally involves assumptions.

Expected returns, inflation, spending, and investment horizons all require estimates.

But future conditions will rarely match those assumptions exactly.

A resilient strategy therefore benefits from flexibility.

That might involve maintaining liquidity, periodically reviewing spending, adjusting asset allocation when circumstances change, or reconsidering withdrawals after unusually strong or weak market periods.

The ability to adapt can be more useful than attempting to construct a forecast that appears precise decades into the future.

Final Thoughts

The sequence of investment returns matters because averages can hide the path a portfolio takes to achieve them. When no money is being withdrawn, the order of returns may have relatively limited influence. Once withdrawals begin, timing can become much more consequential.

A significant decline early in a withdrawal period can reduce portfolio value while simultaneously requiring assets to be sold. That combination may leave less capital available to participate in future recoveries.

This does not mean investors should attempt to predict the next market downturn.

Instead, sequence risk highlights the value of planning around uncertainty.

Liquidity, diversification, asset allocation, spending flexibility, scenario analysis, and regular portfolio reviews can all help create a structure that does not rely on favorable returns arriving at exactly the right time.

Ultimately, long-term investment success depends on more than achieving an attractive average return. The path taken along the way and how the portfolio must be used during that journey can matter just as much.