Sequence of Returns: Why the Order of Gains and Losses Matters

Two people retire in the same January with the same $500,000. Over the next four years they earn exactly the same four annual returns — one bad year, three decent ones — and they each pull out exactly $25,000 a year to live on. Four years later, one has about $25,500 more than the other. Neither made a mistake. The returns just showed up in a different order.

That gap is sequence of returns risk. It is one of the few things in investing where the arithmetic alone, with no fees, no bad picks, and no panic selling, decides who ends up ahead. And it only bites once money starts leaving the account.

Why order is nearly harmless while you save

Say you are 35, contributing every month, withdrawing nothing. A 10% loss followed by a 10% gain leaves you in roughly the same spot as the gain followed by the loss. The reason is that multiplication does not care about order: 0.90 × 1.10 and 1.10 × 0.90 are the same number. Your contributions muddy that slightly — a bad year early means your later contributions buy in cheaper, which usually helps — but the core balance is order-blind.

Withdrawals break the symmetry. A fixed dollar withdrawal is not a percentage, so it does not scale with the account. Take $25,000 out of a portfolio that just fell 20% and you have removed a much bigger slice of what remains. Those shares are gone. They do not participate in the recovery, and every future gain compounds on a smaller base.

The four years, laid out

Both retirees start with $500,000. Both withdraw $25,000 at the start of each year, before that year’s return is applied. Both experience returns of −20%, +5%, +15%, and +8% — an arithmetic average of 2% a year either way.

Retiree A gets them in that order, with the loss first.

Retiree B gets the identical four numbers reversed, with the loss last.

Same starting balance. Same $100,000 withdrawn in total. Same four returns. Retiree A finishes with $404,905.50, Retiree B with $430,408 — a difference of $25,502.50, or roughly one full year of spending.

Where that $25,502 actually went

The tables show the gap. They do not show why it exists, and the why is worth a minute because it tells you which lever matters.

Split each retiree’s outcome into two pieces: what the original $500,000 grew into, and what the withdrawals cost.

The first piece is identical for both. Multiply the four growth factors together — 0.80 × 1.05 × 1.15 × 1.08 — and you get 1.04328 regardless of the order you multiply them in. So the original half-million compounds to $521,640 for Retiree A and $521,640 for Retiree B. Order genuinely does not matter here. This is the saver’s world.

The second piece is where they separate. Each $25,000 withdrawal is removed before a particular string of returns, so each one forfeits a different amount of future growth. Retiree A’s first withdrawal misses out on all four years of compounding, worth a factor of 1.04328. Her second misses the +5%, +15%, and +8% years — a factor of 1.3041. Her third misses +15% and +8%, a factor of 1.242. Her last misses only the +8%. Add those four factors and you get 4.66938, so her withdrawals cost her $116,734.50 of ending balance.

Run the same accounting for Retiree B. His first withdrawal also forfeits 1.04328, because it is still the full four years. But his second withdrawal misses +15%, +5%, and −20%, which multiply to just 0.966. His third misses +5% and −20%, a factor of 0.84. His last one misses only the −20% year, a factor of 0.80. His four factors sum to 3.64928, and his withdrawals cost him $91,232.

$521,640 minus $116,734.50 gives $404,905.50. $521,640 minus $91,232 gives $430,408. The tables and the algebra agree, which is the point of doing it both ways.

Now the mechanism is visible. The two retirees’ first withdrawals cost exactly the same, because both forfeit the same complete set of returns. Everything after that diverges. Retiree A withdrew into the teeth of a recovery, so each dollar she took out was a dollar that would have grown. Retiree B withdrew into a market that was about to fall, so each dollar he took out was a dollar he saved from the drop. Sequence risk is not really about when the crash happens. It is about whether your withdrawals land before the growth or before the loss.

Why the first few years of retirement weigh most

Stretch that logic across a real retirement and the shape becomes clear. A withdrawal in year one of a thirty-year retirement forfeits thirty years of compounding. A withdrawal in year twenty-eight forfeits two. The early withdrawals are simply worth more, so anything that shrinks the balance while those early withdrawals are still being made does disproportionate damage.

That is why planners talk about the “retirement red zone,” the handful of years on either side of the day you stop earning. It is not superstition about market cycles. It is the same arithmetic above, run over a longer horizon: the balance is at its peak, the withdrawals have their longest remaining runway, and a downturn in that window compounds its harm through every subsequent year. A 20% drop in year fifteen hurts, but far less of your future is riding on it.

Four years is a toy horizon. Over twenty-five or thirty, with inflation-adjusted withdrawals and a full sequence of real returns, the gap between a lucky order and an unlucky one can be the difference between a portfolio that outlives you and one that runs dry with years to go.

What people do about it, and what that does and does not accomplish

Two responses show up commonly, and both are worth understanding on their mechanics rather than as recipes.

The first is holding one to two years of spending in cash or short-term instruments. This does nothing about market returns — a down year is a down year. What it does is decouple the withdrawal from the market. If the $25,000 comes out of a cash bucket in a year the portfolio fell 20%, no shares get sold at the bottom, and those shares stay invested for the recovery. In the arithmetic above, it changes which growth factors each withdrawal forfeits. That is a real effect, but it is bought with the return you give up by holding cash in every year, not just the bad ones.

The second is reducing stock exposure as retirement approaches. That is the entire design premise of target date funds, which shift from a stock-heavy mix toward bonds and cash on a preset schedule. The SEC’s investor bulletin on target date funds is blunt about the limits: these funds are not guaranteed, can lose money including at and after the target date, and two funds with the same year in the name can hold very different allocations. A gentler glide path narrows the range of possible bad years. It does not remove the risk, and it lowers expected growth in exchange.

Neither approach makes the order predictable. They change how much a bad order costs.

What this example does not tell you

Four returns, chosen to make a point, isolating one variable. Real markets do not hand you four numbers and stop, and a genuine retirement plan has to carry several things this example deliberately leaves out.

Inflation is the biggest omission. Holding the withdrawal flat at $25,000 for four years is a modeling convenience; in reality the dollar amount has to rise to buy the same groceries. The Bureau of Labor Statistics explains in its Consumer Price Index Q&A how the CPI is constructed and why the index for a national average of urban consumers may not track any individual household’s costs — retirees whose spending skews toward medical care and housing can experience something quite different from the headline figure. Escalating the withdrawals would make both retirees end poorer, and would widen the gap between them, because larger early withdrawals forfeit more compounding.

Taxes are absent too. Whether that $25,000 comes from a traditional 401(k), a Roth, or a taxable brokerage account changes what actually lands in the checking account, and the answer is not the same across account types. Withdrawal timing is simplified as well: one lump at the start of each year, when most people draw monthly or quarterly, which shifts the arithmetic somewhat.

And spending itself is rarely flat. It drifts with health costs, travel, and whatever life delivers. Some retirees deliberately cut withdrawals in down years, which changes the picture in a way a fixed-dollar model cannot show.

The deepest limitation: nothing here says which sequence anyone will get. Nobody knows in advance whether the first retirement year will be up or down. That unpredictability is the actual risk. The arithmetic only shows what is at stake either way.

FAQ

Does sequence of returns risk affect me if I’m still working?

Much less. With contributions going in and nothing coming out, an early downturn mostly means your future contributions buy shares cheaper. As the split above shows, the growth on your existing balance is order-blind — it is the withdrawals that make order matter, so the risk concentrates in the years you start spending the portfolio down.

Can diversification get rid of sequence risk?

No. Diversification changes which assets you hold and how correlated they are, which can shrink the size of a bad year. It has no effect on the order in which returns arrive. A thoroughly diversified portfolio can still post a loss in your first year of retirement, and the withdrawal arithmetic works the same way when it does.

Is a fixed withdrawal amount realistic?

It is a planning assumption, chosen because it is easy to model and easy to compare. Plenty of retirees use flexible rules instead, trimming withdrawals after a down year and raising them after a strong one. Flexibility reduces the damage from a bad sequence — smaller withdrawals forfeit less compounding — at the cost of an income that varies year to year.

Does a longer retirement make sequence risk better or worse?

Longer horizons make the early years matter more, not less. A withdrawal made in year one of a thirty-year retirement gives up thirty years of potential growth, versus four years in the example above. The risk does not spread out over time; it concentrates at the front.

Why do the two retirees have the same average return but different outcomes?

Because an arithmetic average throws away the ordering information, and the ordering is precisely what the withdrawals interact with. Both retirees’ original $500,000 grows by the same 1.04328 factor over four years. The entire $25,502.50 difference comes from the withdrawals — $116,734.50 of forgone growth for the one who sold into a recovery, $91,232 for the one who sold ahead of the drop.

Does holding cash guarantee I avoid selling at a loss?

It buys time, not immunity. One to two years of spending in cash covers a short downturn without touching the portfolio, but a longer or deeper decline outlasts the buffer, and refilling it eventually means selling something. The cash also earns less than the portfolio in every year, including the good ones.

What to look at next

The natural next question is how withdrawal rates themselves get chosen and stress-tested, since that is the practical decision sequence risk feeds into — the $25,000 in this example is 5% of the starting balance, and where that percentage comes from deserves its own treatment. If your own planning uses an inflation assumption, the BLS Consumer Price Index Q&A is the primary source most retirement calculators build on, and worth reading once for what the index does and does not measure.

This article is general information, not financial advice. See our disclaimer.

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