Sequence of Returns Risk Example: Two Identical Portfolios

A sequence of returns risk example shows it plainly: two identical portfolios, the same returns in a different order, and very different results.

What is sequence of returns risk?

Sequence of returns risk is the risk created by the order in which investment returns arrive, rather than the average of those returns. It matters only when money is moving out of the portfolio. A retiree who takes a withdrawal during a down year sells assets at a lower price and permanently removes those shares from the recovery that follows.

This is why two people can retire in the same year, hold the same allocation, earn the same average return over a decade, and end up in completely different financial positions. Averages hide the order. The order is what the retiree actually lives through.

Sequence of returns risk

The risk that a poor run of market returns early in retirement permanently reduces how long a portfolio lasts, even if long-term average returns are fine.

Arithmetic average return

The simple average of annual returns. It ignores the order in which they happened and ignores the effect of withdrawals.

Compound return

The actual growth rate the portfolio experienced, accounting for the order of gains and losses.

Withdrawal rate

The percentage of the portfolio taken out in a given year to fund spending.

Averages describe the market. Order describes your retirement.

What does a sequence of returns risk example actually show?

Here is a simplified, hypothetical illustration. It is not a client outcome, a projection, or a forecast. It exists to isolate one variable.

Two retirees each begin with $1,000,000. Each withdraws $50,000 at the end of every year, held flat for simplicity. Each earns exactly the same five annual returns: negative 15 percent, negative 10 percent, positive 8 percent, positive 20 percent, and positive 25 percent. The arithmetic average of that set is 5.6 percent for both.

The only difference is the order. Portfolio A gets the two down years first. Portfolio B gets them last.

Both retirees end year five having withdrawn the same $250,000. Portfolio A is worth roughly $119,800 less. Same returns. Same withdrawals. Same average. Different order.

And this is only five years. Extend the same pattern across a 25 or 30 year retirement and the gap does not stay at $119,800. Portfolio A is compounding from a smaller base for the rest of the retiree's life, and every future withdrawal represents a larger percentage of what is left.

Why does the order of returns only matter when you are withdrawing?

Run the same two return sets with no withdrawals at all and something useful happens: both portfolios finish at exactly the same number, about $1,239,300. Multiplication does not care about order. A gain of 25 percent and a loss of 15 percent produce the same result whichever comes first.

Withdrawals break that symmetry. Taking $50,000 out of an $850,000 portfolio removes 5.9 percent of it. Taking $50,000 out of a $1,250,000 portfolio removes 4 percent of it. The dollars are identical. The damage is not.

During accumulation, a down market is a discount. During distribution, a down market is a permanent sale.

That single reversal is the reason a plan built for the accumulation years often does not transfer cleanly into the income years. What got you here is not automatically what gets you through the transition.

When are you most exposed to sequence of returns risk?

The exposure is concentrated in a window, not spread evenly across retirement:

• The five years before you stop working. A large drawdown here shrinks the base you were counting on, and you have limited time to rebuild it from earnings.
• The first five to ten years of withdrawals. This is the highest-risk stretch. Poor returns combined with active withdrawals do compounding damage.
• The first year of required minimum distributions. Under current IRS rules, required minimum distributions generally begin at age 73, with the first one due by April 1 of the following year and later ones by December 31. At that point, the withdrawal is no longer optional. If the market is down, you are still required to take it.
• The year of a business sale or liquidity event. A concentrated position converting to a portfolio right before a drawdown creates the same problem from a different direction.

Later in retirement, the risk fades. A bad market in year 22 hurts, but there are fewer remaining withdrawals for it to compound against.

How do you reduce sequence of returns risk?

Nobody can prevent market volatility, and any firm suggesting otherwise is describing something that does not exist. What planning can address is how much of your income has to depend on the market in any given year.

You cannot choose the order of returns. You can decide, in advance, how much of your retirement paycheck is exposed to it.

These levers interact. Building an income floor changes which accounts you draw from, which changes your taxable income, which changes your bracket and potentially your Medicare premiums. That is why sequencing works better when tax strategy, income planning, and portfolio construction are handled as one coordinated plan rather than three separate conversations. For the wider view, see our overview of sequence of returns risk and retirement income, and the mechanics of reducing taxes on IRA and 401(k) withdrawals. Timing questions often intersect with Social Security claiming strategy as well.

Frequently asked questions

Is sequence of returns risk the same thing as market risk?

No. Market risk is the risk that your investments lose value. Sequence of returns risk is the risk that those losses arrive at the worst possible time, specifically while you are withdrawing. Two people can face identical market risk and very different sequence risk depending on where they are in life.

Does sequence of returns risk disappear later in retirement?

It fades, but it does not disappear. The earlier a poor stretch arrives, the more remaining withdrawals it compounds against. A downturn in year two of retirement is a structurally different problem from the same downturn in year 22.

Can I solve this by simply holding more bonds?

Reducing volatility helps, but it introduces a trade-off. A portfolio positioned too conservatively may not keep pace with inflation across a 30 year retirement, which creates a different kind of shortfall. The question is not conservative versus aggressive, it is which dollars need stability and which dollars need growth.

How many years of spending should sit outside the market?

There is no single correct number. It depends on your essential spending, your other income sources, your tax situation, and your tolerance for drawing down a reserve. One to three years of essential expenses is a common starting point for discussion, not a rule.

Does sequence of returns risk affect me while I am still working and saving?

Much less, and in the opposite direction. While you are contributing rather than withdrawing, an early downturn means you buy at lower prices. The risk flips the moment money starts flowing out instead of in, which is why the years immediately around retirement deserve their own review.

Sources

1. IRS, Retirement Plan and IRA Required Minimum Distributions FAQs, for the age at which required minimum distributions begin and the applicable deadlines.
2. Social Security Administration, Delayed Retirement Credits, for how delaying a claim increases the monthly benefit.
3. U.S. Securities and Exchange Commission, Investor.gov: Assessing Your Risk Tolerance, for the relationship between time horizon and investment risk.