What it means
Imagine two investors who earn the exact same average return on their investments over thirty years. The first investor suffers heavy stock market crashes in their very first year of retirement while cashing out funds for living expenses.
The second investor enjoys strong growth initially, with the market crashes happening much later. Despite identical averages, the first investor risks running out of money completely, while the second investor thrives.
This happens because of simple mathematics. When you sell investments during a market downturn to pay bills, you must sell a larger number of shares to raise the same cash.
Those shares are gone forever and cannot participate in the eventual market recovery. This creates a permanent scar on your portfolio balance, known as capital depletion.
For business owners and managers, this concept applies directly to cash flow management, owner draw schedules, and corporate treasury planning. If a business needs to liquidate investments or assets to fund operations during a market slump, the financial damage is magnified compared to liquidating the same assets during a boom.
Understanding this risk changes how we plan for the future. Instead of relying on average returns, financial planners use stress-testing to see how portfolios survive worst-case scenarios in the early years.
By holding cash buffers or flexible income sources, people and businesses can ride out early storms without selling assets at the worst possible time. Imagine baking a cake and dropping the first slice on the floor versus dropping the last slice.
If you drop the first slice, you lose a big portion immediately and have less to share, even though you made the same total number of slices.
In practice
Real-world examples
Example 1
An agency owner retiring with $1,000,000 starts taking annual withdrawals during a stock market crash. Because share prices are low, the owner must sell about twice as many units to raise $50,000, which drains the fund quickly. When the market recovers, there are fewer units left to benefit.
Example 2
A manufacturing company liquidates part of its investment reserve to cover payroll during a sector downturn. Selling assets at depressed prices locks in permanent losses and slows the firm's recovery. A cash buffer would have let it wait.
Example 3
A tech startup founder sells early-stage shares during a broader market correction to fund a house purchase. This permanently lowers her wealth compared with waiting for the market to recover. The same sale a year later would have raised more money.
Think of it
Imagine baking a cake and dropping the first slice on the floor versus dropping the last slice. If you drop the first slice, you lose a big portion immediately and have less to share, even though you made the same total number of slices.
Formula
Calculation
Portfolio Value at Year End = (Starting Value - Withdrawal) x (1 + Return for the Year).
Worked example: start with $100,000, withdraw $10,000 and suffer a 20% drop. ($100,000 - $10,000) x 0.80 = $90,000 x 0.80 = $72,000 remaining.
Now compare the same two returns in a different order. Two investors each start with $1,000,000 and withdraw $50,000 at the start of each year. Investor A earns -20% in year 1 and +20% in year 2: ($1,000,000 - $50,000) x 0.80 = $760,000, then ($760,000 - $50,000) x 1.20 = $852,000. Investor B earns +20% first and -20% second: $950,000 x 1.20 = $1,140,000, then ($1,140,000 - $50,000) x 0.80 = $872,000. Both had the same average return, but A ends $20,000 behind purely because the bad year came first.Case study
Seen in the real world
This is a fictional, illustrative scenario. Oakwood Design, a mid-sized design consultancy, built a reserve fund of $2,000,000 invested in equities to support future expansion and director pensions. In the year the founding directors retired and began drawing $100,000 at the start of each year, the stock market dropped by 25%. After the withdrawal, the fund was $1,900,000 and the fall left it at $1,900,000 x 0.75 = $1,425,000. The market then rose by 20% in year two.
After the second $100,000 withdrawal, the fund grew to ($1,425,000 - $100,000) x 1.20 = $1,590,000. Had the 20% gain come first and the 25% fall second, the fund would have been ($1,900,000 x 1.20 - $100,000) x 0.75 = $1,635,000, which is $45,000 higher on exactly the same returns. Oakwood learned a hard lesson about timing. It restructured its treasury policy to hold two years of withdrawals, $200,000, in safe bank accounts, so the firm would never again be forced to sell investments during a slump.
Watch out
Common mistakes
- Assuming that long-term average returns are what actually matters for financial survival.
- Failing to keep a cash buffer to cover immediate expenses during market downturns.
- Ignoring the danger of taking large withdrawals right at the start of a retirement or business transition period.
Questions
People also ask
Why does the timing of returns matter so much?
Because taking money out of a falling portfolio forces you to sell more units, locking in permanent losses that miss out on future recoveries.
How can I protect my business or personal finances from this risk?
Keep one to two years of living or operating expenses in safe cash accounts so you never have to sell investments when markets are low.
Does this risk apply only to retirees?
No. Any business or individual who needs to withdraw cash from a fluctuating portfolio during a downturn faces this exact same danger.