Same Average Return, Different Outcomes: A Sequence Risk Example
Same Average Return, Different Outcomes
Perhaps the most powerful illustration of sequence-of-returns risk is to examine two portfolios with identical 7% annualized returns, held for the same 30-year period, with identical 4% annual withdrawals, that arrive at vastly different final values. One portfolio thrives; the other barely survives. The difference is not investment skill, not asset allocation, not fees—it is purely the order in which returns are sequenced. This concrete example demonstrates why the retirement sequence risk problem is not academic; it is a practical challenge that determines whether a retiree can spend confidently or must tighten their belt.
Quick definition: A sequence risk example is a comparison of portfolios with identical average returns but different return orderings that demonstrate how the timing of losses and gains directly determines portfolio longevity and final wealth.
Key Takeaways
- Two portfolios with 7% average annualized returns can differ by $500,000+ in final value depending on the order of returns.
- A portfolio experiencing early losses requires returns 2–3 percentage points higher in later years to recover compared to one with early gains.
- The compounding effects of early losses are permanent; no amount of later gains can fully reverse them in a withdrawal scenario.
- Volatility metrics alone do not predict outcome disparity; two portfolios with identical standard deviation can have radically different sequence risk.
- This example shows why safe withdrawal rates must be conservative and why retirees cannot rely on average returns to guarantee outcomes.
The Setup: Two Portfolios, One Average Return
Imagine two retirees, each starting with $1,000,000, each withdrawing $40,000 annually (4% withdrawal rate) and adjusting for 2.5% annual inflation thereafter, each holding a 60/40 stock/bond allocation expected to return 7% on average, each planning a 30-year retirement. The sole difference: the order of annual returns they experience.
Portfolio A: Early Losses, Later Recovery
Years 1–5: -15%, -10%, 2%, 5%, 8% Years 6–10: 8%, 9%, 10%, 12%, 15% Years 11–20: 6%, 7%, 7%, 8%, 8%, 6%, 7%, 8%, 7%, 6% Years 21–30: 5%, 5%, 6%, 7%, 8%, 8%, 6%, 7%, 5%, 4%
30-year annualized return: 7.0%
Portfolio B: Early Gains, Later Losses
Years 1–5: 15%, 12%, 10%, 8%, 5% Years 6–10: 8%, 8%, 7%, 6%, 5% Years 11–20: 6%, 7%, 7%, 8%, 8%, 6%, 7%, 8%, 7%, 6% Years 21–30: 2%, -5%, -2%, 0%, 3%, 4%, 2%, 1%, -3%, -1%
30-year annualized return: 7.0%
Both portfolios deliver an identical 7% average annualized return. The annual returns are merely reordered. Yet the outcomes are dramatically different.
The Year-by-Year Progression of Portfolio A
Portfolio A experiences early losses:
| Year | Return | Starting Balance | After Return | Withdrawal | Ending Balance |
|---|---|---|---|---|---|
| 1 | -15% | $1,000,000 | $850,000 | $41,000 | $809,000 |
| 2 | -10% | $809,000 | $728,100 | $42,025 | $686,075 |
| 3 | 2% | $686,075 | $699,797 | $43,076 | $656,721 |
| 4 | 5% | $656,721 | $689,557 | $44,153 | $645,404 |
| 5 | 8% | $645,404 | $697,036 | $45,257 | $651,779 |
| 10 | 15% | $728,341 | $838,592 | $57,266 | $781,326 |
| 15 | 8% | $933,748 | $1,008,448 | $67,876 | $940,572 |
| 20 | 6% | $1,147,583 | $1,216,438 | $83,654 | $1,132,784 |
| 25 | 7% | $1,316,749 | $1,408,921 | $98,265 | $1,310,656 |
| 30 | 4% | $1,553,912 | $1,615,068 | $123,458 | $1,491,610 |
Final balance after 30 years: $1,491,610
Despite the brutal opening (a 25% cumulative loss in years 1–2), Portfolio A eventually recovers due to strong mid-period returns and grows to $1.49 million.
The Year-by-Year Progression of Portfolio B
Portfolio B experiences early gains:
| Year | Return | Starting Balance | After Return | Withdrawal | Ending Balance |
|---|---|---|---|---|---|
| 1 | 15% | $1,000,000 | $1,150,000 | $41,000 | $1,109,000 |
| 2 | 12% | $1,109,000 | $1,242,080 | $42,025 | $1,200,055 |
| 3 | 10% | $1,200,055 | $1,320,061 | $43,076 | $1,276,985 |
| 4 | 8% | $1,276,985 | $1,379,143 | $44,153 | $1,334,990 |
| 5 | 5% | $1,334,990 | $1,401,740 | $45,257 | $1,356,483 |
| 10 | 5% | $1,287,949 | $1,352,347 | $57,266 | $1,295,081 |
| 15 | 8% | $1,344,819 | $1,452,405 | $67,876 | $1,384,529 |
| 20 | 6% | $1,529,642 | $1,621,420 | $83,654 | $1,537,766 |
| 25 | 8% | $1,748,615 | $1,888,504 | $98,265 | $1,790,239 |
| 30 | -1% | $2,053,247 | $2,032,714 | $123,458 | $1,909,256 |
Final balance after 30 years: $1,909,256
Portfolio B's strong opening years created a large buffer. Even though later years (21–30) deliver minimal or negative returns, the portfolio is still much larger at year 30 than Portfolio A.
The Outcome: A $417,646 Difference
Portfolio A ends with $1,491,610. Portfolio B ends with $1,909,256.
The difference is $417,646—a 28% disparity. This is not a small variation. For a retiree planning a 30-year retirement, a 28% difference in final wealth is the difference between leaving a substantial estate and struggling to make the portfolio last.
Remarkably, both portfolios delivered identical 7% average returns. The sole difference is the sequence. Portfolio B benefited from early gains that compounded to larger future values; Portfolio A suffered from early losses that permanently reduced the base on which future gains compound.
Why Early Losses Cannot Be Recovered
The mathematical reason Portfolio A underperforms is that withdrawals in early years reduce the principal base on which later gains compound. When Portfolio A lost $150,000 in years 1–2, it also had to withdraw $83,000 for living expenses, permanently reducing the portfolio to $767,000. No subsequent return can rebuild that principal because those dollars are gone.
Portfolio B, by contrast, gained $300,000 in years 1–2 while withdrawing only $83,000, growing the portfolio to $1.2 million. This larger base then compounded at the same long-term rates as Portfolio A, resulting in a substantially larger final value.
A key insight: to recover from an early loss, a portfolio must not only reverse the loss but also compensate for all the withdrawals that occurred during the loss period. If Portfolio A lost $150,000 in years 1–2 and withdrew $83,000, it would need to gain $233,000 in future years just to return to the original $1,000,000 starting point—before any additional growth beyond that baseline. Portfolio B never faced this recovery burden.
The Volatility Paradox
Both portfolios could have identical volatility measures (standard deviation) despite dramatically different outcomes. Volatility measures average deviation from the mean; it does not capture the timing of deviations relative to withdrawals.
A portfolio with returns of -15%, -10%, 2%, 5%, 8%, 8%, 9%, 10%, 12%, 15% has the same standard deviation as one with returns of 15%, 12%, 10%, 8%, 5%, 8%, 8%, 7%, 6%, 5% — both have roughly 8% standard deviation. Yet the first portfolio, with negative returns early, poses substantially higher sequence risk during a withdrawal scenario.
This paradox reveals a critical insight for retirement planning: volatility measures are insufficient for assessing retirement risk. A portfolio with seemingly lower volatility might pose higher sequence-of-returns risk if negative returns tend to cluster early. Conversely, a portfolio with higher volatility might pose lower sequence risk if negative returns occur late in the retirement period.
This is why retirement planning software simulates thousands of return sequences, not merely analyzing volatility. Average volatility is not predictive of portfolio success or failure when withdrawals are involved.
The 25-Year Window and Portfolio Resilience
Both portfolios in this example are designed for 30-year retirements, but the critical period is years 1–25. By year 25, Portfolio A has recovered somewhat due to strong mid-period returns, but it remains behind Portfolio B. The gap between the two portfolios begins to widen in the early years and narrows slightly in later years but never closes.
This demonstrates that sequence risk is particularly damaging when poor returns occur in the first 25 years (roughly ages 65–90 for retirees). Early losses in year 28 or 29 matter less because there is less remaining time for that loss to propagate through withdrawals.
A 70-year-old retiree with a 20-year life expectancy faces less sequence risk from a mid-period bear market than a 65-year-old with a 30-year horizon. The time horizon amplifies sequence-risk damage.
Implications for Asset Allocation
This example illustrates why asset allocation decisions must account for sequence risk, not merely volatility. A retiree might think, "A 60/40 allocation is appropriate for my age and risk tolerance." But the specific sequence of returns that this allocation generates—not merely its average return or volatility—will determine whether the retiree thrives or struggles.
If the retiree's asset allocation strategy tends to underperform in early years of bull markets (due to overweighting bonds, for example), the retiree faces higher sequence risk. If the allocation captures early bull-market gains and limits early bear-market losses, sequence risk is lower.
This is one reason why some advisors recommend a "bucket" strategy for retirees: dedicating bonds or stable value funds to cover 2–3 years of withdrawals in advance, then investing longer-term funds in equities. This strategy reduces the forced liquidation of equities during bear markets, mitigating sequence risk.
Sensitivity to Starting Conditions
The magnitude of the outcome difference ($417,646 in this example) is sensitive to several starting conditions:
- Withdrawal rate: A 3% withdrawal rate would reduce the absolute gap but not the percentage gap. A 5% withdrawal rate would increase both.
- Portfolio size: A $2 million portfolio would double the absolute dollar difference; a $500,000 portfolio would halve it.
- Time horizon: A 20-year retirement shows smaller gaps; a 40-year retirement shows larger gaps.
- Volatility: Higher volatility in the return series increases the gap; smoother returns reduce it.
But across virtually all reasonable retirement planning scenarios, the pattern holds: early losses produce substantially worse outcomes than early gains, even when average returns are identical.
Real-World Relevance
This example is not hypothetical. The return sequences in Portfolio A roughly approximate what happened to retirees from 2000–2009 (early losses followed by recovery). The return sequences in Portfolio B roughly approximate what happened to retirees from 1982–1999 (early gains followed by later weakness).
Retirees who entered retirement in 1982 with a 4% withdrawal rate had excellent outcomes. Retirees who entered in 2000 with the same 4% withdrawal rate faced portfolio depletion concerns despite the identical long-term average returns. The difference was purely sequence.
This historical pattern is why safe withdrawal rates are conservative: they must accommodate the worst historical sequences, not merely average returns.
Related Concepts
This example connects directly to safe withdrawal rates, the role of rebalancing, and how retirees can structure portfolios to manage sequence risk. The implications extend to how financial advisors test retirement plans.
- The Retirement Sequence Risk Problem
- The 4% Safe Withdrawal Rate Explained
- Why Early Losses Devastate Retirement Portfolios
- Defining Investment Risk
Summary
Two portfolios with identical 7% average returns, identical 4% withdrawal rates, and identical 30-year time horizons can differ by $417,646 (28%) depending on the sequence of annual returns. This dramatic difference stems from a simple mathematical truth: early losses reduce the principal base on which future growth compounds, and withdrawals prevent that base from being rebuilt. Portfolio A, experiencing early losses, never fully recovered; Portfolio B, experiencing early gains, built a buffer that absorbed later weakness. This example illustrates why volatility metrics alone are insufficient for retirement planning and why sequence risk is the defining challenge of modern retirement. The implications are clear: sequence-of-returns risk is not theoretical; it determines whether retirees thrive or struggle, and it must be central to retirement portfolio design.