What's the average rate of return in the stock market? Most people would answer something between 7% to 10%, but that's just a long-term average. The market can go much higher or lower than that in any given year. The sequence of those returns can be very important for retirees to address the biggest risks.

What is sequence-of-returns risk?

Poor stock market returns can create big problems if they occur early in retirement. Most people start withdrawing from their retirement account once they've stopped working since they no longer have earned income to cover monthly bills and lifestyle expenses.

However, you're locking in losses by taking money out of your retirement account when the market is down. When stocks eventually return to growth, you'll have less capital to capture that growth. If you're withdrawing too much, your account might never recover.

Consider the following two scenarios. In both cases, the investor is retiring with $1 million worth of investments and withdrawing $40,000 per year.

Scenario 1

Year Rate of Return (Decline) Distributions Year-End Account Value
1 (18%) $40,000 $780,000
2 (18%) $40,000 $599,600
3 6% $40,000 $595,576
4 30% $40,000 $734,249
5 30% $40,000 $914,523

Calculations by author.

Scenario 2 

Year Rate of Return (Decline) Distributions Year-End Account Value
1 30% $40,000 $1,260,000
2 30% $40,000 $1,598,000
3 6% $40,000 $1,653,880
4 (18%) $40,000 $1,316,182
5 (18%) $40,000 $1,039,270

Calculations by author.

These two examples both have 6% average rates of return, but the annual returns occur in reverse order. Despite the being mirror-images of each other, the outcomes are meaningfully different.

Scenario 1 forces the retirees to sell investments that have temporarily decline in price. In Scenario 2, a financial advisor who reviews your account might recommend increasing your annual distributions to $41,600, based on the 4% Rule. That's $5,000 per year higher than an advisor would recommend for the first scenario. $5,000 can go a long way in retirement. 

It's also important to consider that this example is over a five-year time frame. The gap might be much wider over a longer period. And while the above scenarios are hypothetical, they aren't far-fetched.

People who retired in 2000 faced three straight years of big losses. Retirees who left work in 1970 experienced the opposite.Your retirement probably won't start with a three-year bear market, but it's still not a good idea to gamble on that.

Happy older couples talking and laughing.

Image source: Getty Images

What's the actual problem?

The threat posed by the sequence of returns is really about longevity and cash flow. After all the years of hard work, saving, and investing, a couple of bad years in the market could derail your retirement right as it begins. That's scary for people who no longer have the option to work, earn income, and replenish their savings.

Remember: A larger pool of assets generates more cash, and gives you a longer timeline to stretch your capital. Your retirement fund has to cover expenses for the longer-lived spouse, which means that your assets need to last more than two decades for most households. 

When people don't manage this risk appropriately, they tend to make decisions that make the situation even worse. It's common to "chase" a high rate of return by taking on too much risk. That could bail someone out of a tough situation following a few years of losses, but it might just exaggerate the existing issues by sending account values lower.

It's best to come up with an investment plan to address these risks ahead of time, then stick to the plan if and when things get hairy.

How to address sequence-of-returns risk

If you never want to worry about sequence of returns, the keys are managing volatility and developing a great income investing strategy.

How to manage stock market volatility: Volatility is an unavoidable consequence of stock market investing. Individual stocks and entire indexes fluctuate in value every day, and that fluctuation can be fairly extreme in times such as market crashes.

Young people have the luxury of waiting out bear markets because they have time for their assets to recover to long-term growth. If you're retired, you don't necessarily share that luxury. That's exactly why the sequence of returns is so impactful for seniors.

To combat volatility, retirees should have bonds in their investment portfolios. Bond prices vary on an open market just like stocks, but diversified bond portfolios have historically been far less volatile than stocks.

How to balance your portfolio: The exact percentage of ideal bond allocation varies by age and personal circumstances. The general rule of thumb is to subtract your age from 100 to 120, then make that number the percentage of your investments held in stocks. For example, a 70-year-old would aim for 30% to 50% in stocks, with the balance allocated to bonds. Doing this will shield you from the impacts of market dips early in retirement.

Bonds are also useful sources of income. Bondholders typically receive income in regular intervals, which can be used to replace income from work.

Dividends are another important source of retirement cash flow, and dividend stocks can also help reduce volatility within your stock portfolio. Stable companies with reliable dividends, such as Dividend Aristocrats, are usually good investments for this role. Most Dividend Aristocrats are currently paying 2% to 4% dividend yields, and investment-grade corporate bond yields are generally in the same range.

If your investment portfolio is generating enough income, you can live off those cash flows without selling your assets. By staying invested, you don't lock in losses during a market downturn, and the sequence of returns won't threaten your financial plan.