Sequence of Returns Risk: The Hidden Danger in Early Retirement

Two retirees with identical portfolios and identical average returns over 30 years can have completely different outcomes. The difference is the order in which those returns occur. This is sequence of returns risk, and it is the biggest threat to early retirees.

Why Sequence Matters

Imagine you retire with $1 million and withdraw $40,000 per year. In Scenario A, the market drops 20% in your first year, then recovers. In Scenario B, the market grows steadily for 10 years, then drops 20%.

Both scenarios have the same average return. But in Scenario A, you withdrew $40,000 from a portfolio that just dropped to $800,000. You locked in losses and have less money to benefit from the recovery.

In Scenario B, your portfolio grew to $2 million before the drop. A 20% decline still leaves you with $1.6 million. The same percentage loss hurts far less.

The Early Years Are Critical

Research shows that the first 5 to 10 years of retirement determine most outcomes. Bad returns early, combined with withdrawals, create a hole that good returns later cannot fill.

This is why the 4% rule has a built-in buffer. The rule survived every historical period, including retirees who started in 1966 before a decade of poor returns and high inflation.

How to Protect Against Sequence Risk

Lower initial withdrawal rate. Starting at 3.5% instead of 4% provides more cushion against bad early years.

Build flexibility into your plan. Ability to reduce spending during downturns dramatically improves survival rates. Morningstar research shows flexible retirees can safely start with withdrawal rates of 5% or higher.

Maintain a cash buffer. Having 1 to 2 years of expenses in cash or short-term bonds allows you to avoid selling stocks during downturns.

Consider a bond tent. Some retirees increase bond allocation in the years surrounding retirement, then gradually shift back to stocks. This reduces exposure during the critical early years.

Part-time income option. The ability to earn even small amounts during a market crash provides enormous protection. This is part of why BaristaFIRE appeals to many.

The Good News

Sequence risk is highest in early retirement and decreases over time. If your portfolio survives the first decade, the remaining years are much safer. You have proven your plan works in real conditions.

Additionally, sequence risk only affects those withdrawing from their portfolio. If you delay retirement during a market crash, you avoid the worst effects entirely.