Sequence risk

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   By Guest Blogger Ryan Lewenza

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Risk is something we spend a lot of time thinking about and risk comes in many forms. From a portfolio perspective, we try to minimize risk for clients by building a balanced and diversified portfolio. In a balanced portfolio with investments spread across different assets, geographies, size and factors (e.g., dividend and value stocks), this helps to reduce risk and downside in portfolios. From a macro perspective, we try to minimize risks like tariffs, the threat of inflation or recession by tilting the portfolio to more defensive areas like dividend paying stocks, REITs and low risk government bonds.

Well, there’s another risk we’re trying to address, particularly for retired clients – called sequence risk – which refers to the impact on portfolios based on the order or ‘sequence’ of portfolio returns. Essentially, the timing of gains or losses can have an impact on the portfolio and longevity. Sequence risk doesn’t matter much in the accumulation phase, but it sure does in the decumulation phase. Let me explain.

When you’re in the accumulation phase, that is saving for your retirement, the sequence of returns is less important than your average long-term return. An example will help. In the table below we consider three different scenarios/portfolios, each with a different sequence of returns.

One scenario (Portfolio A) had high early returns but then negative returns in the end and the other scenario (Portfolio C) had losses initially then followed by gains in the end. A third scenario (Portfolio B) assumes a simple average return of 5% and note that the averages are all the same under the different scenarios. The sequence of returns had no impact on the portfolio value at the end of the investment period.

Sequence of returns for different portfolios

Source: Turner Investments

Here’s another chart illustrating the performance and ending values of these three scenario/portfolios. All three portfolios start at $1 million and by the fifth year, given their average returns are all the same, they all end up at the same ending value of $1,274,000. Again, due to the different sequence of returns, the pathway of the three portfolios is different, but after the five years they end up in the same place.

$1 million portfolios grow to $1,274,000 with a 5% return over five years

Source: Turner Investments

This is very different when in the decumulation phase, with returns mattering a lot more as you start to draw down the portfolio to fund your retirement. This is because you’re forced to sell investments after a big initial drop, to meet your yearly draw/spending needs, resulting in a lower portfolio value to support future retirement payments.

The chart below hits home this point. Both investors start with $1 million retirement portfolios, and they both draw $50,000/year from the portfolio (with 2% inflation adjustments each year). Investor 1 experiences a 15% drop in the first two years of retirement, while Investor 2 is luckier and doesn’t experience a 15% decline until the 10th year of retirement. Investor 1 runs out of money by the 19th year, while Investor 2 still has over $400k left. This clearly shows how impactful the sequence of returns can be for investors in retirement and those starting to draw on their investment portfolios to fund their retirement spending needs’

Impact of sequence risk for reyierees drawing from portfolios

Source: Schwab Center for Financial Research

So, how do we and clients deal with addressing and minimizing sequence risk?

First, build a balanced and diversified portfolio (using ETFs of course). By spreading investments across different asset classes, such as equities and fixed income, this helps to reduce portfolio volatility and downside risk. Different assets react differently to economic conditions so having a diversified portfolio can help to reduce overall risk. For example, government bonds tend to rally during a bear market or ‘risk off’ period, so if you were forced to sell some investments to fund your retirement spending needs, you could sell/trim the bonds, which are likely flat or up, rather than selling equities which are down.

Second, in the first year or two of retirement, have a cash reserve strategy, where you keep the amount you’ll need for that first year or two in cash or money market investments. Basically, put aside what you’ll need for that first year or two in retirement. This way, if there is a big drop in the markets, you’re not forced into selling when markets are down as you’ve already set these funds aside. This just requires a little bit of planning and why having a financial advisor with this knowledge and these strategies can help a lot.

Finally, if possible, consider scaling back you’re spending and therefore portfolio withdrawals during a down market. If the portfolio has taken a 10-15% hit, then consider reducing your withdrawals until the portfolio ultimately recovers. So, take a year off from going on a big trip until the markets get back in gear.

There’s a lot to be fearful and concerned about, especially today with the high inflation, two ongoing wars, an unpredictable and chaotic US president, but retirement should be as stress free as possible, and it just requires some planning to deal with these different financial risks.

Now you know how to address ‘sequence risk’.

Ryan Lewenza, CFA, CMT is a Partner and Portfolio Manager with Turner Investments, and a Senior Investment Advisor, Private Client Group, of Raymond James Ltd.

Source: https://www.greaterfool.ca/2025/03/22/sequence-risk-2/