Sequence-of-Returns Risk: Why the First Years Matter Most

Two retirees each start with $500,000. Each takes $40,000 at the start of the year. In year one, Retiree A’s portfolio falls 20% and Retiree B’s rises 20%. In year two the returns swap: A gains 20%, B loses 20%. Over the two years they see the very same returns, with an average of zero. They don’t end in the same place.

The arithmetic

Now take the withdrawals away. Starting from $500,000, a 20% loss followed by a 20% gain ends at $480,000, and the reverse order lands on $480,000 too, because multiplication doesn’t care about order. The whole $16,000 difference comes from the withdrawals.

That is sequence-of-returns risk. The order of returns only matters once money is leaving the account.

Why the bad year hurts more

Think in shares. Say a fund sells at $100 a share and you need $40,000. You sell 400 shares. If the price has dropped to $80, the same $40,000 takes 500 shares.

Those extra 100 shares are gone for good. When the price recovers, they aren’t there to recover with it, and the portfolio climbs back from a smaller base, which means every later withdrawal takes a larger bite, and a retirement that began with one bad year can end years earlier than an identical one that began with a good year.

Both retirees made their first withdrawal at the same starting value. Retiree A made the second one after the fall. Retiree B made it after the rise, and that one sale accounts for the full $16,000.

Two years of numbers understate it. Stretch the same pattern over a longer fall, or several poor years at the start, and the gap can grow large enough to decide whether the money lasts at all, because each year of selling low compounds the one before it and the portfolio has less and less left to recover with. A bad stretch twenty years in does much less harm, since by then a much smaller share of the money you will ever spend is still exposed to it.

Defenses that sell fewer shares

None of these removes the risk. Each one cuts how many shares you have to sell at low prices.

1. Keep a cash reserve. Hold a year or two of withdrawals in cash or short-term savings. In a down year, spend the cash and leave the stocks alone to recover. Refill the reserve after the market comes back.
2. Stay flexible on withdrawals. The guardrails from the lesson on withdrawal rates do exactly this. A cut in a bad year sells fewer shares at the low.
3. Hold a lower stock share in the first years. A portfolio with less in stocks falls less in a crash, so less has to be sold at depressed prices, and the stocks you do hold get the years they need to come back before you have to touch them. Some retirees then raise the stock share gradually once the riskiest early years are past.

Each defense has a cost. Cash earns little. Flexible withdrawals mean spending less in some years. A lower stock share means less growth when the early years turn out fine. You’re buying protection for the stretch where one bad run does the most harm.

The 4% rule sets out how a starting rate holds up when a bad sequence arrives early. Try both orders yourself in the retirement withdrawal calculator: put the fall in year one, then in year ten, and compare the endings.

The first defense, a cash reserve, is the start of a bucket plan. The final lesson builds one around the income gap from the first lesson and adds a floor of guaranteed income under your spending, so the bills you cannot skip get paid whatever the market does in the years that matter most.