Sequence of Returns Risk: Same Returns, Different Investor Outcome

Sequence of Returns Risk: Same Returns, Different Investor Outcome

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Learning objective

Learn why the order of investment returns matters when money is entering or leaving a portfolio, how early losses can damage a withdrawal plan, and how to stress-test the interaction between market returns and cash flow.

If a portfolio has no deposits or withdrawals, reversing the order of the same annual returns produces the same final value. Multiplication does not care about the order. Once an investor withdraws money, however, the timing matters: a loss early in the withdrawal period leaves less capital to participate in a later recovery, while the withdrawals continue removing units.

The Pensions Regulator describes sequencing risk as the fact that the impact of investment performance depends on when it occurs. MoneyHelper similarly warns that taking money while markets are low leaves fewer investments to recover later, particularly in the early years of retirement.

Step 1: distinguish average return from the return path

A long-term average compresses many different journeys into one number. It does not show:

• whether large losses arrive early or late;
• when deposits or withdrawals occur;
• how much capital is exposed at each point;
• whether spending rises with inflation;
• fees, taxes and forced sales;
• whether the investor can reduce or delay a withdrawal.

Two portfolios can experience the same set of annual returns and still finish with different values because cash flow changes the amount exposed before the next return.

Worked example

Consider two hypothetical portfolios. Each starts with £100,000, experiences the same three returns—−20%, +10% and +20%—and withdraws £10,000 at the end of each year. Fees, tax and inflation are ignored.

Path A: the loss comes first

1. £100,000 × 0.80 − £10,000 = £70,000
2. £70,000 × 1.10 − £10,000 = £67,000
3. £67,000 × 1.20 − £10,000 = £70,400

Path B: the loss comes last

1. £100,000 × 1.20 − £10,000 = £110,000
2. £110,000 × 1.10 − £10,000 = £111,000
3. £111,000 × 0.80 − £10,000 = £78,800

Both paths contain exactly the same returns and total withdrawals, but Path B ends £8,400 higher.

Without withdrawals, both would finish at £105,600:

£100,000 × 0.80 × 1.10 × 1.20 = £105,600

The difference is produced by the interaction between return order and cash flow, not by a different average market performance.

Step 2: map every cash flow

Build the test around actual timing rather than an annual average. Include:

• regular withdrawals;
• one-off large expenses;
• pension, salary or rental income;
• contributions;
• fees and taxes;
• inflation adjustments;
• required minimum cash balances.

A portfolio that funds essential spending has a different capacity for loss from one whose withdrawals are optional. FINRA's investor guidance separates willingness to take risk from the ability to absorb losses and highlights the need to align liquidity with the time when money will be needed.

Step 3: test bad returns at the vulnerable time

Do not rely only on the historical order of returns. Run at least three versions:

1. the planned or central path;
2. the same returns with the worst years moved to the beginning;
3. a prolonged weak period with higher inflation and normal withdrawals.

Also test a large expense during the early decline. The purpose is not to forecast the exact future. It is to see whether the plan remains workable when unfavourable timing arrives.

For a longer analysis, use many simulated or bootstrapped return paths, but keep their assumptions visible. A model can understate risk if it assumes stable volatility, normal distributions or constant correlations.

Step 4: define response options before a decline

Possible planning tools include:

• keeping near-term essential spending in liquid, lower-volatility assets;
• setting a range rather than a rigid withdrawal amount;
• reducing optional spending after a defined portfolio decline;
• using secure income for essential expenses where appropriate;
• reviewing asset allocation as the withdrawal date approaches;
• scheduling regular reviews of portfolio value and withdrawals.

These are planning choices, not universal prescriptions. Holding more cash can reduce the need to sell after a fall, but it may also reduce long-term expected growth. Lower withdrawals preserve capital but may not meet spending needs. Product, tax and pension decisions can be complex and may require regulated advice.

Step 5: monitor funded status, not just performance

An investment can outperform a benchmark while the plan still weakens if withdrawals, inflation or the remaining horizon are higher than assumed. Track:

• current portfolio value;
• annual essential and optional withdrawals;
• years of planned withdrawals remaining;
• liquid spending reserve;
• realised and expected fees;
• asset allocation and concentration;
• the withdrawal amount as a percentage of current value.

Recalculate after a large market move, major withdrawal, change in income or material change in time horizon. A fixed percentage based on the original portfolio can become much larger relative to the reduced current value after a drawdown.

Contributions reverse the intuition

Early losses are especially damaging during withdrawals, but they can help a long accumulation plan if regular contributions buy more units at lower prices and the market later recovers. The same return sequence can therefore affect a saver and a withdrawer differently. Cash-flow direction is central to the analysis.

Common mistakes

• Using average return as if it described every possible path.
• Testing returns without deposits and withdrawals.
• Ignoring a large loss in the first years of drawdown.
• Assuming withdrawals can remain fixed regardless of portfolio value.
• Treating cash as costless or equities as certain to recover on schedule.
• Forgetting fees, tax and inflation.
• Using one historical period as a complete stress test.
• Confusing willingness to take risk with capacity to fund losses.

Practical checklist

• List every expected deposit and withdrawal with its timing.
• Separate essential spending from optional spending.
• Model the same returns in favourable and unfavourable orders.
• Add fees, tax assumptions and inflation.
• Test a major early loss and a longer weak period.
• Define liquidity reserves and withdrawal-adjustment rules.
• Review asset allocation before and during the withdrawal phase.
• Recalculate after major market, income or spending changes.
• Seek regulated financial advice for pension, tax or product decisions when needed.

Sources

• MoneyHelper: How to invest pensions in retirement
• The Pensions Regulator: Investing to fund DB—sequencing risk
• FINRA: Know Your Risk Tolerance

This tutorial was prepared with AI-assisted research and writing under The Money Man editorial workflow. It is educational information, not personalised investment, pension or tax advice. Returns are uncertain, the example is hypothetical and withdrawal suitability depends on individual circumstances.