Sequence of Returns Risk: Why When Matters as Much as How Much
Two retirees can earn exactly the same average return over exactly the same years and end up in very different positions. The difference is the order those returns arrived in.
The same average, two very different outcomes
Sequence of returns risk is the observation that when money is flowing out of a portfolio, the order in which investment returns arrive changes the result — even if the average return across the whole period is identical. It is a genuinely counterintuitive idea, because most of the way investing is discussed treats the average as the thing that matters. Over a period with no deposits or withdrawals, the average really is all that matters: multiply the same set of annual returns together in any order you like and you land on exactly the same number. Introduce regular withdrawals and that neat property breaks. Money taken out during a downturn is capital that is no longer in the portfolio when prices recover, and no subsequent good year can put it back. Two people who retire a year apart, hold identical portfolios and live through the same decade of market history can therefore end up in materially different positions, purely because one of them met the bad years first.
A deliberately simple illustration
The mechanism is easiest to see with numbers small enough to check by hand. What follows is an illustrative example using hypothetical figures — it is not a projection, a forecast, or a claim about any real market. Imagine two retirees who each start with 100,000 in a portfolio and withdraw 5,000 at the end of each year. Across three years they experience exactly the same three annual returns — minus 20 percent, zero, and plus 20 percent — but in opposite orders. Retiree A meets the bad year first; Retiree B meets it last.
- Hypothetical Retiree A, in the order minus 20, zero, plus 20 percent: the portfolio ends year one at 75,000, year two at 70,000, and year three at 79,000.
- Hypothetical Retiree B, in the reverse order plus 20, zero, minus 20 percent: 115,000, then 110,000, then 83,000.
- Both withdrew 15,000 in total and both experienced precisely the same three annual returns.
- With no withdrawals at all, both portfolios would have finished at exactly 96,000 — the 4,000 gap only appears once money is being taken out.
Why the early years carry the weight, and why accumulation is different
A 4,000 gap after only three years, produced by nothing but reordering, and the effect compounds as the horizon lengthens. The reason is that a withdrawal taken in a down year represents a larger fraction of the portfolio than the same withdrawal taken in a good one. Retiree A’s first 5,000 came out of a portfolio worth 80,000, while Retiree B’s came out of 120,000, and the extra units sold are permanently absent from every subsequent year’s compounding. That is also precisely why the risk is concentrated in the first several years of drawdown: a bad run early hits the largest balance the plan will ever have and shrinks the base everything afterwards depends on, whereas a bad run twenty years in affects a portfolio that has already done most of its work. The same logic explains why accumulation is a different story altogether. Someone still contributing is buying during downturns rather than selling into them, so an early bad stretch buys more units cheaply — unhelpful for the balance printed on today’s statement, but not structurally damaging in the way an early drawdown loss is.
Over a period with no cash flows, only the average return matters. Once money is coming out, the calendar matters too.
Several approaches are commonly discussed as ways of managing this, and it is worth being explicit that what follows describes what people do rather than recommending any of it. One is holding a cash or short-bond buffer covering a year or more of spending, so that withdrawals during a bad year can come from the buffer instead of from assets that have fallen; the trade-off is the long-run return given up by holding it. Another is a flexible withdrawal rule, where spending is trimmed after poor years and increased after good ones rather than fixed in advance; the trade-off there is an income that varies, sometimes uncomfortably. A third is a glidepath — deliberately changing the asset mix as retirement approaches and progresses, in either direction, since some researchers argue for de-risking into retirement and others for the opposite. Which of these, if any, suits a particular person depends on their spending flexibility, their other income sources such as state or workplace pensions, and their tolerance for variability. Nothing above recommends a specific strategy, product or allocation.
This article is educational and general in nature. It isn’t personalized investment, tax, or legal advice — always weigh your own circumstances, or talk to a licensed professional, before making financial decisions.