Sequence of Returns Risk: Why the Order of Market Returns Matters

Average returns are a poor guide to retirement outcomes, because retirees do not simply hold investments. They sell some every year to pay the bills. That changes the math: once money is flowing out, the order in which good and bad years arrive matters as much as their average. Planners call this sequence of returns risk, and it is one of the main reasons the first years of retirement are considered the most sensitive.

The core idea

During the years you save, a market drop is uncomfortable but not necessarily harmful, since your contributions buy more shares at lower prices. In retirement the effect reverses. When you withdraw from a falling portfolio, you sell more shares to raise the same dollars. Those shares are gone and cannot participate in the recovery.

Two things combine to create the risk:

1. Withdrawals reduce the number of shares you own.
2. Early losses hit a portfolio at its largest, before time and growth can build a cushion.

The same string of returns delivered in the opposite order, with the good years first, leaves the retiree in a very different position.

A simple illustration

The numbers below are hypothetical and chosen for easy arithmetic. They are not a forecast and do not represent any real investment.

Imagine two retirees, each starting with $1,000,000 and withdrawing $40,000 at the start of every year, with no inflation adjustment. Over four years, each portfolio earns the same four annual returns: +20%, +10%, -20% and -30%. The only difference is the order.

Both have the same average and the same cumulative return before withdrawals, since multiplication does not depend on order. But once you subtract $40,000 each year before returns are applied, the ending balances differ.

• Retiree A (good years first): $960,000 grows 20% to $1,152,000; minus $40,000 is $1,112,000, grows 10% to $1,223,200; minus $40,000 is $1,183,200, falls 20% to $946,560; minus $40,000 is $906,560, falls 30% to $634,592.
• Retiree B (bad years first): $960,000 falls 30% to $672,000; minus $40,000 is $632,000, falls 20% to $505,600; minus $40,000 is $465,600, grows 10% to $512,160; minus $40,000 is $472,160, grows 20% to $566,592.

After four years, Retiree A has about $634,600 and Retiree B has about $566,600, even though both took out identical dollars and earned identical returns. The gap would keep widening if the pattern continued, because Retiree B is left with a smaller base on which the recovery can work.

When the risk is greatest

Researchers and planners often point to a window of roughly five to ten years around the retirement date, sometimes called the retirement red zone. Three conditions make it dangerous:

• The portfolio is at or near its peak size, so a large percentage loss is a large dollar loss.
• Withdrawals are starting, so there is no new money cushioning the fall.
• There is less time to recover, since the retiree may not have decades to wait for markets to rebound.

A person who retires into a long bull market and one who retires just before a deep decline can have very different experiences with the same plan.

How it connects to the 4% rule

The widely cited guideline known as the 4% rule came from analysis of historical US market sequences, and its design was driven by the worst sequences in the data rather than the average ones. In other words, the rule is built around sequence risk. Our article on how much you need to retire explains what the rule does and does not say, and why withdrawal rates are better thought of as starting points than guarantees.

Ways people manage it

None of these is a perfect fix, and each involves trade-offs. They are tools that planners model, not instructions.

1. Hold a cash or short-term reserve

Keeping a year or two of expected withdrawals in cash or short-term, high-quality bonds means you may not have to sell stocks after a drop. The trade-off is that cash earns less over the long run and can lag inflation.

2. Use a bucket approach

A bucket strategy divides money by time horizon: near-term spending in cash and short-term bonds, mid-term in intermediate bonds or balanced holdings, and long-term in stocks. Refilling the near-term bucket from the others is a rule-driven way to avoid selling stocks at a bad time. It is mostly a behavioral structure, since the overall asset mix still drives risk. For how mix and diversification work, see asset allocation and diversification.

3. Be flexible with spending

Adjusting withdrawals in response to markets is among the most effective approaches, because it directly reduces the number of shares sold during declines. Variations include:

• Skipping the inflation adjustment after a down year
• Trimming discretionary spending temporarily
• Guardrail rules, which raise or cut withdrawals when the portfolio crosses preset thresholds

The cost is variable income, so it works best when essential expenses are covered by stable sources.

4. Build a floor of guaranteed income

Social Security, pensions and annuities pay regardless of market conditions, so they reduce how much the portfolio has to provide. Delaying Social Security can raise the monthly benefit, which is why claiming age is part of the sequence discussion. Annuities have their own costs, terms and insurer-credit risks, and our overview of annuities explains the main types.

5. Adjust asset allocation near retirement

Some people reduce stock exposure as retirement approaches, which is the idea behind many target-date funds. Others keep a higher stock share but pair it with a larger reserve. A glide path that rises again in the early years of retirement is another approach studied by researchers. These strategies reflect different views on risk, and there is no consensus on the best one.

6. Work a little longer or earn some income

Part-time income in the first years of retirement reduces withdrawals when the portfolio is most vulnerable. Even a modest amount can make a difference to the math.

What does not help

• Trying to time the market. Moving fully to cash after a decline can lock in losses and miss the recovery.
• Ignoring inflation. A strategy that avoids volatility but loses purchasing power over decades simply swaps one risk for another.
• Relying on average returns in a spreadsheet. A projection that uses a constant yearly return hides this risk entirely.

Testing your own plan

A fee-only planner or a retirement calculator can run your plan through a range of scenarios rather than one average, and some use historical sequences or thousands of simulated paths. Look for tools that show what happens if returns are poor in the first five years, not just the typical outcome. The output is usually a probability, not a promise, and it depends on the assumptions about returns, inflation, taxes and lifespan that you supply. The IRS and the Social Security Administration publish official rules on taxes, required distributions and benefits at irs.gov and ssa.gov, and those rules affect any withdrawal plan.

Takeaway

Sequence of returns risk does not mean retirement investing is unworkable. It means that the early years deserve extra care, and that flexibility, a spending reserve and some stable income can matter as much as the headline return. Plans that expect bumpy years, rather than an average, tend to be easier to stick with when markets fall.