Drawdown and sequence

Average return is the number everybody quotes. It conceals two things that decide real outcomes: how far the journey fell, and when.

Drawdown

Maximum drawdown is the largest fall from a peak to a subsequent trough. Not a year's return — a peak-to-trough decline, which can run across several years.

It matters for two reasons the average return cannot express.

It is what you actually experience. Nobody feels an annualised figure. They feel the portfolio being worth a third less than it was eighteen months ago, with no indication of when that stops.

It is the number that decides whether you hold. Chapter 1: volatility becomes permanent loss only when you are forced to sell. The forcing is done by the drawdown, not by the average.

So the useful question before any allocation is not "what does this return?" but "what is the worst this has done, and could I have sat through it?" Chapter 9 of the mutual funds subject said the same about rolling returns: the worst window is the most informative figure and the one no advertisement carries.

Sequence risk

The subtler one, and it surprises people who understand drawdown perfectly well.

If you invest a lump sum and never touch it, only the compound return matters — the order of the yearly returns makes no difference to the final value. Multiplication is commutative.

The moment money flows in or out, the order starts to matter enormously.

Take ₹1 crore, withdraw ₹6 lakh a year, and suppose the next three years return −20%, −10% and +30%.

• Year 1: ₹1 crore falls to ₹80 lakh, withdraw ₹6 lakh → ₹74 lakh
• Year 2: falls to ₹66.6 lakh, withdraw ₹6 lakh → ₹60.6 lakh
• Year 3: rises to ₹78.8 lakh, withdraw ₹6 lakh → ₹72.8 lakh

Now the same three returns in the opposite order: +30%, −10%, −20%.

• Year 1: ₹1 crore rises to ₹1.3 crore, withdraw ₹6 lakh → ₹1.24 crore
• Year 2: falls to ₹1.116 crore, withdraw ₹6 lakh → ₹1.056 crore
• Year 3: falls to ₹84.5 lakh, withdraw ₹6 lakh → ₹78.5 lakh

Identical returns, identical average, and a difference of several lakh after three years. Extend it over a retirement and the gap becomes the difference between money lasting and not.

The mechanism: withdrawing during a fall sells more units for the same rupees, and those units are not there for the recovery.

It runs the other way too

For someone accumulating, bad early returns are a gift.

Chapter 4 of the mutual funds subject: a SIP buys more units when the NAV is low. A young investor whose first five years are poor is buying cheaply with every contribution, and the recovery applies to a larger unit count.

So the same sequence that ruins a retiree helps an accumulator. Which gives the practical rule:

Sequence risk is small when you are adding money, and largest when you start taking it out.

The danger zone

The years immediately before and after you stop earning.

At that point the portfolio is at its largest, contributions stop, and withdrawals begin. A severe fall in that window does damage that later good years cannot undo, because the capital that would have recovered was spent.

Three defences, none requiring a forecast.

Hold several years of spending outside equities. Chapter 12 of the fixed income subject: money with a date needs an instrument matched to it. Spending from the bond allocation during an equity fall lets the equities recover untouched.

Reduce equity exposure gradually approaching the transition, and rebuild afterwards if appropriate.

Flex the withdrawal. Taking slightly less in bad years preserves units, and small flexibility early prevents large problems later. This is the single most effective lever, and chapter 7 of the retirement subject returns to it.

Reading a track record properly

Three numbers instead of one.

The average or annualised return — what gets quoted.

The maximum drawdown — what you would have had to survive.

The worst rolling period of your horizon — if you need the money in seven years, the worst seven-year outcome is the relevant figure, not the best thirty-year one.

A strategy with a slightly lower average and a much smaller drawdown is frequently the better one to actually hold, because held is the only version that earns anything.

The point

Maximum drawdown is the peak-to-trough fall, and it decides whether you stay invested. Sequence risk means the order of returns changes the outcome whenever money is flowing — harmless or helpful while accumulating, and most dangerous in the years around retirement, where holding several years of spending outside equities is the defence.