Sequence Risk Explained: Why Withdrawals Change Everything

Introduction

Sequence-of-returns risk, often shortened to sequence risk, is the idea that the timing of investment returns matters a lot when you are taking money out of your portfolio. Two retirees can see the same average returns over time, but if one experiences big losses early while withdrawing money, that retiree may run out of money much sooner.

Why does this matter to you? If you're planning retirement or thinking about regular withdrawals, you need to understand how early market swings can change the outcome of your plan. What happens if the market falls right after you start withdrawing? How can you protect your nest egg without giving up growth?

This article explains sequence risk in plain language, shows a simple numeric example that makes the math obvious, and gives practical guardrails you can use right away. You'll learn about cash buffers, withdrawal flexibility, portfolio choices, and common mistakes to avoid.

• Sequence risk means early losses can permanently reduce your withdrawing power even if long-term returns recover.
• Withdrawing before a market recovery makes losses worse, because you're selling assets on the downside.
• A simple example shows two retirees with the same average returns can end with very different balances when withdrawals happen.
• Practical guardrails are a short-term cash buffer, flexible spending rules, and a diversified portfolio mix like $VTI with $AGG.
• Use a bucket strategy, reduce withdrawals in bad markets, and plan for contingencies instead of assuming a fixed withdrawal forever.

How sequence-of-returns risk works

When you're not withdrawing, your portfolio simply compounds with returns. Withdrawals change that math, because they remove capital that could have benefited from later gains. If losses come early, you have less money left to recover when markets rebound.

Think of it this way: you're pruning a tree after a storm, then hoping it regrows. If you cut branches when the tree is weak, it takes longer to get back to full shape. Withdrawals right after losses are like that pruning at the worst time.

Key idea, in plain numbers

Suppose you start with $1,000,000 and you withdraw $40,000 each year. If the market loses 20% in year one, you'll have a smaller base for future growth than if the market gained 20% in year one. Even if average returns over several years are identical, the order of gains and losses changes the ending balance.

Simple numeric example: same average, different endings

Here is a short, concrete example that shows exactly why sequence risk matters. We'll assume withdrawals happen at the start of each year. That is conservative and it makes the effect clear.

Start portfolio: $1,000,000. Annual withdrawal: $40,000, which is 4% of the starting balance. We compare two five-year return sequences that both average 5% arithmetic per year, but in different order.

1. Sequence A, bad start: Year returns are -20%, -10%, +10%, +20%, +25%.
2. Sequence B, good start: Year returns are +25%, +20%, +10%, -10%, -20%.

Both sequences have the same arithmetic mean return, 5% per year. But withdrawals happen before returns each year, so the math diverges.

Sequence A results, year by year:

1. Start $1,000,000, withdraw $40,000, balance $960,000, return -20% -> $768,000
2. Withdraw $40,000 -> $728,000, return -10% -> $655,200
3. Withdraw $40,000 -> $615,200, return +10% -> $676,720
4. Withdraw $40,000 -> $636,720, return +20% -> $764,064
5. Withdraw $40,000 -> $724,064, return +25% -> $905,080

Ending balance after five years: approximately $905,080.

Sequence B results, year by year:

1. Start $1,000,000, withdraw $40,000 -> $960,000, return +25% -> $1,200,000
2. Withdraw $40,000 -> $1,160,000, return +20% -> $1,392,000
3. Withdraw $40,000 -> $1,352,000, return +10% -> $1,487,200
4. Withdraw $40,000 -> $1,447,200, return -10% -> $1,302,480
5. Withdraw $40,000 -> $1,262,480, return -20% -> $1,009,984

Ending balance after five years: approximately $1,009,984. Same average returns, but the retiree who had early losses ends with about $105,000 less. That gap matters, especially if withdrawals continue for decades.

Why early losses hit hardest

Early losses force you to sell more shares or fund units to support spending. With less capital left, subsequent gains compound on a smaller base. Even a later recovery can't fully erase the damage if you keep withdrawing.

This is why retirees entering a bear market in the first 5-10 years of retirement face a higher chance of running out of money, compared with retirees whose early years are strong. Sequence risk is highest at the start of a withdrawal phase, and it applies to any withdrawal schedule, whether systematic distributions or living expenses.

Practical guardrails for future planners

You don't need to be a professional investor to reduce sequence risk. There are simple, practical actions you can take to improve portfolio longevity and calm your nerves when markets wobble.

1. Short-term cash buffer

Keep 1-5 years of planned withdrawals in cash and short-term bonds. That lets you avoid selling equities after a big drop. For many people, three years of withdrawals is a reasonable middle ground. If your withdrawals are $40,000 a year, a three-year buffer is $120,000 in cash or a money market fund.

2. Bucket strategy

Divide your portfolio into time-based buckets. For example, a short-term bucket in cash for the next 2-3 years of spending, a mid-term bucket in bonds for years 4-10, and a long-term bucket in equities like $VTI for growth beyond year 10. Each bucket has a purpose, and you avoid selling growth assets at a low point to fund near-term needs.

3. Flexible withdrawals

Consider a dynamic spending rule instead of a fixed percentage. In bad markets reduce discretionary spending modestly, and in good markets allow normal spending. Small, temporary cuts early in retirement can greatly improve portfolio survival without a permanent reduction in lifestyle.

4. Portfolio allocation and diversification

A mix of equities and bonds can lower short-term volatility, but bonds also lower expected returns. Many retirees use a baseline like 60% equities and 40% bonds, adjusting for age, risk tolerance, and withdrawal needs. Diversify within equities using broad funds, for example $VTI for U.S. stocks and $SPY for S&P 500 exposure, and consider $AGG or $BND for broad bond exposure.

5. Contingency planning

Plan for what you'll do if markets fall and remain depressed for several years. That could include tapping a line of credit, temporarily increasing part-time work, or using a progressive annuity to provide a guaranteed floor for essential expenses. You don't have to take those steps, but having options reduces panic if markets decline.

Real-world examples and context

Many retirees rely on withdrawal rules of thumb like a 4% initial withdrawal, sometimes called the 4% rule. Historical studies show the 4% rule worked well in many U.S. market periods, but it is not guaranteed to succeed in every sequence of returns and every asset allocation. That's the point: the rule assumes a typical sequence, but you could be unlucky and retire into a severe market downturn.

Imagine two retirees both invested 70% in $VTI and 30% in $AGG, both following the same spending plan. One enters retirement in 1999 and experiences the dot-com crash in the next five years, then 2008. The other enters in 2010 and sees steady gains early. Their portfolios and withdrawal outcomes differ even if the multi-decade average is similar. Sequence risk explains why.

Common mistakes to avoid

• Assuming average returns tell the whole story, ignoring the order of returns, avoid this by testing plans with downside scenarios.
• Having no cash buffer, which forces selling stocks at market lows, create a 1-3 year cash reserve at minimum.
• Sticking rigidly to a fixed dollar withdrawal when markets crash, instead use a flexible rule or small temporary cuts.
• Overconcentration in single stocks like $AAPL or $MSFT, which can lead to large swings early on, diversify across funds and sectors instead.
• Ignoring longevity and inflation risk, plan for longer retirement horizons and factor in rising costs.

FAQ

Q: What is the biggest factor that makes sequence risk dangerous?

A: The biggest factor is withdrawing money during a market downturn, because you reduce the capital that could benefit from later recoveries. Early losses combined with withdrawals amplify downside effects.

Q: Can bonds eliminate sequence risk?

A: Bonds reduce portfolio volatility and can lower sequence risk, but they also tend to lower long-term returns. Bonds are part of the solution, but they do not completely eliminate the risk unless you sacrifice growth.

Q: How big should my cash buffer be?

A: That depends on your tolerance for risk and your spending needs. Many planners suggest 1-3 years of withdrawals in cash or short-term bonds, while conservative retirees may keep 3-5 years. The right size balances safety and opportunity cost.

Q: If markets fall, should I stop withdrawals entirely?

A: Not necessarily. Rather than stopping completely, consider small temporary reductions, tapping your cash buffer, or switching to a lower withdrawal rate until markets recover. The goal is to avoid forced selling of growth assets at depressed prices.

Bottom Line

Sequence-of-returns risk makes the timing of market returns crucial when you are taking withdrawals. Early losses matter more because they shrink the base that future returns can grow. You can see this clearly with a simple numeric example where two identical average-return sequences end very differently because of order.

Take action by building a short-term cash buffer, using a bucket strategy, keeping withdrawals flexible, and diversifying your portfolio. At the end of the day, planning for sequence risk is about protecting options and reducing the chances you must sell at the worst possible time.

Next steps: calculate your expected withdrawal needs, set aside a multi-year cash buffer, and run a few worst-case return sequences to see how your plan holds up. If you want a deeper simulation, explore historical rolling-period analyses for your portfolio mix and time horizon.