The Same Average Return, Two Very Different Outcomes
Imagine two people retire with identical $1,000,000 portfolios and withdraw the same amount each year. Over 25 years, they both average a 7% annual return. Yet one runs out of money by year 20, and the other finishes with more than they started. The only difference: the order in which the good and bad years happened. This is sequence of returns risk, and it is one of the least understood dangers in retirement planning.
Why Order Matters When You’re Withdrawing Money
While you’re still working and adding money to your portfolio, the order of returns barely matters, because you have decades to recover from a downturn. But once you start withdrawing a fixed amount each year, a market drop early in retirement forces you to sell more shares at depressed prices just to cover expenses. Those shares are gone for good, so they can’t participate in the eventual recovery. A portfolio that loses 20% in year one and then recovers has far less capital left to compound than one that gains early and dips later, even though the average return over time is identical.
The Danger Zone: Five Years Before and After Retirement
Financial researchers generally point to a roughly ten-year window, spanning the five years before retirement and the five years after, as the period where sequence risk does the most damage. A severe downturn in this window can permanently shrink the size of the nest egg you have left to draw from, even if markets fully recover shortly afterward. This is why someone retiring in a strong bull market and someone retiring just before a crash can have drastically different long-term outcomes, despite doing everything else the same way.
Practical Ways to Reduce the Risk
You cannot control when the market drops, but you can control how exposed you are when it does. Keeping one to three years of living expenses in cash or short-term bonds lets you avoid selling stocks during a downturn, giving your portfolio time to recover before you tap it again. Some retirees also use a “bond tent,” gradually increasing bond allocation in the years approaching retirement and then slowly shifting back to stocks afterward. Flexible withdrawal strategies help too: reducing withdrawals slightly during down years, rather than sticking to a fixed percentage no matter what, preserves more capital for the recovery.
The Takeaway
Average annual return is a useful long-term planning number, but it hides the real risk that determines whether your money lasts: when the bad years happen relative to when you start spending. Understanding sequence of returns risk won’t let you predict the market, but it will help you build a retirement plan that can survive a bad run of luck in exactly the years it matters most.
