Sequence-of-Returns Risk: Why Return Order Matters During Withdrawals

Two portfolios can earn the same set of annual returns yet finish with different balances. The deciding factor is not necessarily what they own or their average return. It may be when gains and losses occur relative to withdrawals.

Sequence-of-returns risk is a timing risk around withdrawals and falling markets that can leave two otherwise similar portfolios with substantially different amounts. It applies whenever money is being taken from a fluctuating portfolio—not only in one particular type of account or at one stage of life.

Why withdrawals make the order matter

Consider a fixed initial investment with no contributions or withdrawals. If it gains 20% in one year and loses 20% in another, reversing those years does not change the ending value:

Multiplication produces the same result in either order. The arithmetic average return is 0%, although the investment ends below its starting value because a 20% loss applies to a different balance than a 20% gain.

Withdrawals change that calculation. Money removed after an early decline is no longer present to participate in a later recovery. The same dollar withdrawal also consumes a larger proportion of a smaller portfolio. By contrast, early gains can create a larger base from which withdrawals are taken.

This is why the same returns in reverse order led one hypothetical portfolio to run out in year 21 while another finished 25 years with more than twice its starting assets. Both began with $430,096, followed the same inflation-adjusted withdrawal pattern and experienced exactly the same returns; only the sequence differed.

A two-year example

Without withdrawals, both sequences end at $96. With two identical $10 withdrawals, the gain-first portfolio ends at $78 and the loss-first portfolio at $74.

The difference appears because the first $10 withdrawal equals 8.3% of the $120 balance in the gain-first sequence but 12.5% of the $80 balance in the loss-first sequence. After that larger proportional reduction, the second portfolio has less money available when its positive return arrives.

The example also resolves a common misunderstanding: matching average returns do not guarantee matching outcomes. Average return, total compounded return and ending balance after cash flows answer different questions. Once money enters or leaves a portfolio, the timing of those cash flows becomes part of the result.

Sequence risk is not the same as ordinary volatility

Volatility concerns fluctuations in returns. Sequence risk concerns the order of those fluctuations in relation to cash flows.

A volatile return path does not necessarily create different ending values for two untouched lump sums receiving the same returns. Add withdrawals, however, and early losses can become especially consequential. Evidence-based illustrations describe how withdrawal size and market conditions can dramatically affect how long a portfolio lasts.

That distinction also explains why a later recovery may not fully repair the damage. The market may recover, but the dollars already withdrawn cannot share in that recovery. A favorable return applied to a reduced balance produces fewer dollars than the same return applied to a larger balance.

Sequence risk should not be confused with a claim that a decline is certain, that losses will come early or that one return pattern can be forecast. The point is exposure to an unknown order. The fact that markets cannot be predicted makes withdrawal planning sensitive to several possible paths rather than a single assumed average.

The variables that can change the effect

The severity of sequence risk depends on how returns and withdrawals interact. Useful variables to examine include:

• Withdrawal amount. A larger withdrawal removes a greater share of the portfolio, all else equal. A smaller withdrawal leaves more invested, although spending needs and other constraints may limit flexibility.
• Withdrawal flexibility. FINRA presents cutting back on extras after a loss as one way to give a fluctuating portfolio an opportunity to recover. That is a planning lever, not an assurance of recovery.
• Timing within a year. Taking one annual amount and taking several smaller amounts expose the portfolio to different points in the market path. One educational approach suggests that splitting a yearly withdrawal into smaller monthly amounts can smooth market volatility and reduce dependence on a single withdrawal date.
• Source of near-term withdrawals. Another framework describes keeping a year of withdrawals in a money market fund as a way to lessen the effect of market swings on scheduled spending. This changes where near-term withdrawals come from; it does not remove market risk from the remaining investments or guarantee a particular outcome.
• Return order. Early positive returns generally provide a larger base for subsequent withdrawals, while early negative returns combine market losses with portfolio outflows. Later returns still matter, but they apply to whatever balance remains.

These variables interact. For example, a flexible withdrawal taken after a gain creates different arithmetic from a fixed withdrawal taken after a loss. Evaluating only the assumed average return leaves that interaction hidden.

A practical test for any withdrawal illustration

When reviewing a projection, ask four questions:

1. Are withdrawals included? If not, the illustration may not reveal sequence risk.
2. When are they taken? Beginning-of-year, end-of-year and periodic withdrawals can produce different calculations.
3. Are withdrawals fixed or adjusted over time? The cited 25-year illustration increased the first withdrawal by 2.5% in each subsequent year, which affected the amount removed.
4. Does the projection show multiple return orders? A single smooth average-return line cannot demonstrate how early losses and early gains produce different paths.

The central idea is mechanical rather than predictive: returns determine how the invested balance changes, while withdrawals determine how much remains exposed to later returns. When those events occur in a different order, the ending balance can change even when the list of returns and total dollars withdrawn are otherwise identical.

Sources

1. RMD strategies for down markets — fidelity.com
2. Retirement Income Planning — fidelity.com
3. Managing Your Retirement Portfolio | FINRA.org — finra.org
4. Set up your retirement withdrawals | Vanguard — investor.vanguard.com