Paul Merriman’s site, FundAdvice.com, has an excellent paper on the consequences of drawdown for retirees. He points out that withdrawals during the drawdown period sap the ability of the portfolio to recover in a subsequent rally.

“When you’re accumulating money, what matters (at least mathematically) is how much you wind up with eventually. If you get to your goal, it doesn’t matter much how you got there. If your portfolio lost 45 percent the first year and then enjoyed an unending run of 14 percent annual gains (this is too good to be true in real life, but it makes the point well), you could be happy. In 16 years, you would nearly quadruple your money.

But here’s something that might surprise you : That very same hypothetical scenario – a serious loss followed by unending 14 percent gains, could spell disaster for a retiree. Those returns seem very favorable. But in a $1 million portfolio from which $60,000 is taken the first year and the withdrawal is raised by 3.5 percent every year, those returns would leave an investor broke after 16 years.”

Paul interprets this to mean that a retiree should switch into bonds to reduce risk of drawdown and accept lower returns. The problem with this strategy (apart from the lower returns) is inflation. Not only will inflation drive up rates and reduce the value of bonds, but it will reduce the purchasing power of the portfolio and can be just as serious, albeit more insidious, as a stock market decline. I interpret this to mean a broader set of asset classes must be used, for example including commodities to offset inflation, as well as market timing to at least avoid serious declines.