Sequence-of-Returns Risk: Why the First Five Years of Retirement Matter More Than the Next Twenty

Two retirees can experience identical average returns over 30 years and end up in completely different situations, purely because of the order the good and bad years arrived in. That is sequence-of-returns risk, and it is the biggest reason two people who looked the same at 65 do not look the same at 80.

While you are saving, order barely matters. The day you retire it reverses: withdrawals replace contributions, and timing matters as much as the average.

A Simple Way to See It

Consider an illustrative comparison. Two retirees, each starting with $1M, each withdrawing $50,000 a year adjusted upward for inflation, each earning a 6% average annual return over 30 years. The first sees strong markets in years 1 through 10 and weak ones in years 21 through 30. The second gets the reverse.

The average, the withdrawals and the horizon all match. The first ends with money left over. The second, in many realistic scenarios, runs out before age 90.

When you withdraw from a portfolio that just dropped 25%, each withdrawal is a larger percentage of a now-smaller base, and compounding can no longer repair the damage. Research has consistently found the worst outcomes cluster around poor returns in roughly the first 5 to 10 years. After that, a portfolio has either survived its stress test or been damaged in a way that gets harder to recover from.

Three Practical Defenses

What you can control is how exposed your spending is to a bad market when it arrives.

1. A cash and short-bond buffer. Many plans hold 1 to 3 years of essential expenses in cash, Treasury bills (T-bills), or short-duration bonds. The buffer exists so you are never forced to sell stocks in a drawdown to fund groceries.
2. Flexibility in the non-essentials. Plans that separate must-spend (housing, food, healthcare, insurance) from want-to-spend (travel, gifts) hold up better. Trimming discretionary spending modestly in a down year can preserve value over a 30-year horizon.
3. A deliberate path on equity exposure. Some research suggests starting retirement with lower equity exposure and raising it through the first decade. Concentration in volatile assets costs the most in the earliest years.

Two things get misdiagnosed as sequence risk: a withdrawal rate set too high for the portfolio to sustain even in average markets, and a plan with no flexibility in it.

The Takeaway

Where the first 24 months of retirement spending comes from changes the answer. If the honest answer is "I would sell stocks," the exposure is real no matter how the projection looks. If it comes from a buffer, a pension, or Social Security already claimed, the same drop is an inconvenience you can wait out.

The risk is highest for careful savers who build a diversified portfolio, keep costs low, hold through every downturn, then carry those same habits into the year withdrawals start. Holding through a downturn works while contributions flow in. Once withdrawals start, the same habit can mean selling stocks at the bottom.

If you are within a few years of retiring, how those first five years get funded is worth working through while you can still build the buffer on your own schedule.

The information provided is for educational purposes only and does not constitute investment, legal, or tax advice. Consult with qualified professionals for guidance specific to your situation.