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Sequence of Returns Risk, Explained With Two Retirees

October 6, 2026 · 8 min read · By Prakash Damodaran

Imagine you did everything right. You saved for decades, built a seven-figure portfolio, picked a sensible withdrawal rate, and retired. And then the market crashed in your first year. Through no fault of your own, your retirement is now in worse shape than someone with the exact same investments who retired a few years earlier or later. This is not a story about bad luck in the stock market. It is a story about the order of returns, and it has a name: sequence-of-returns risk.

Who are the two retirees?

Let us call them Asha and Meera. Both retire in the same year with $1,000,000. Both plan to spend $40,000 a year, a 4% starting withdrawal, taken at the beginning of each year. Over the next ten years, both earn the exact same set of annual returns, averaging 5.5% a year. The only difference: the order is reversed. Asha gets the bad years first and the good years later. Meera gets the good years first and the bad years later.

What returns did each of them get?

Asha's ten years run: down 25%, down 10%, up 5%, up 20%, up 25%, then up 8% a year for five years. Meera's ten years are the mirror image: up 25%, up 20%, up 5%, down 10%, down 25%, then up 8% a year for five years. Same returns, same average, opposite order. If returns were all that mattered, both would end in the same place.

What happened to their money?

They did not end in the same place. After year one, Asha's portfolio sits at about $720,000 while Meera's sits at about $1,200,000. The gap is already enormous. After five years, Asha has about $790,900 and Meera has about $901,230. After ten years, Asha ends with about $909,000 and Meera ends with about $1,071,000, a difference of about $162,000, even though both started with $1,000,000, both withdrew $40,000 a year, and both earned the same average return.

Asha never ran out of money, but her margin of safety is badly eroded, and she is ten years older with less room to recover. Meera, with identical investments and identical discipline, is comfortably ahead.

Why does the order matter more than the average?

Because withdrawals turn paper losses into permanent ones. When Asha withdraws $40,000 from a $720,000 portfolio, that is a 5.6% bite out of a shrunken pie. When Meera withdraws $40,000 from a $1,200,000 portfolio, it is only a 3.3% bite. Every dollar Asha sells during the crash is a dollar that cannot participate in the recovery that follows. The shares are gone. The recovery happens without them.

This is the part most people miss: average returns are a useful summary of the market, but your portfolio does not experience the average. It experiences the years in order, and when you are withdrawing, the bad years early on do damage that the good years later cannot fully repair.

Could Asha have caught up?

In theory, yes, but look at what it would take. After five years, Asha has about $790,900 and Meera has about $901,230. For Asha to close a $110,000 gap while both keep withdrawing $40,000 a year, she would need several years of returns well above average, the kind of luck nobody can plan on. And that is the gentle version of the story. Stretch the example to fifteen or twenty years, the way a real retirement runs, and the gap does not stay politely at $162,000. It compounds, because the smaller portfolio throws off less growth every single year while the same withdrawals keep coming out.

This is also why the danger is asymmetric. If you retire into a bull market, the worst case is that you end up richer than you needed to be. If you retire into a crash, the worst case is running out of money while you are still alive. Planning for sequence risk is planning for the side of the asymmetry that can actually hurt you.

When does this hurt the most?

In the first five years of withdrawals. That window is the danger zone, and financial researchers treat it that way: a crash in year two of retirement is a genuine threat, while the same crash in year twenty is a footnote. The math is the same math as above, just with different stakes. Early on, the portfolio is at its largest, withdrawals are a bigger share of it, and there is the most time ahead for the damage to compound.

This is also why a lower withdrawal rate is the simplest defense. Remember the FI math: your FI number is your annual recurring spending divided by your withdrawal rate, plus one-time expenses on top. At 4%, the standard starting point for roughly 30-year horizons, your number is 25 times spending. At 3%, it is 33 times spending. That extra cushion is not pessimism. It is insurance against the bad-order scenario.

Would a lower withdrawal rate help?

Yes, and it is the most reliable defense because it works without any decisions in the moment. If Asha had started at a 3% withdrawal, $30,000 a year instead of $40,000, every crash-year withdrawal would have been a smaller bite out of a smaller pie, and her recovery would have been stronger. The trade-off is real: 3% means a bigger FI number, 33 times your spending instead of 25 times, which means working longer or spending less. Whether that trade is worth it depends on your time horizon and how much safety you want to buy.

What is flexible spending?

The second defense is the willingness to spend less in bad years. If the market drops 20%, you trim the year's discretionary spending: the big trip waits, the renovation pauses, the generous version of the budget becomes the lean version. Even a temporary 10 to 15% spending cut during crash years dramatically reduces the damage, because it shrinks withdrawals exactly when withdrawals hurt most. This works best if you decide the rules in advance, while markets are calm, so you are executing a plan instead of making panicked decisions.

What is a cash buffer?

The third defense is keeping one to two years of spending in cash or short-term bonds, separate from the stock portfolio. In a crash year, you spend from the buffer instead of selling stocks at the bottom. The shares stay invested, the recovery happens with them, and you refill the buffer in good years. The cost is modest: that cash earns little, which is a small drag in normal years. The benefit is that you never have to be a forced seller in the years when selling does the most damage.

What does this mean if you are not retired yet?

Two things. First, sequence risk is mostly a withdrawal problem, so while you are still saving, keep saving: your biggest contributions land when your portfolio is biggest, which is exactly when crashes hurt most, and buying through a crash is the mirror image of Asha's problem. Second, the years just before you retire are the time to build the defenses: decide your withdrawal rate, write your flexible-spending rules, and start building the cash buffer. You cannot control when the crash comes. You can control whether you are ready when it does.

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