Sequence-of-Returns Risk: Why the Order of Investment Gains and Losses Matters

What sequence-of-returns risk actually means

Investment returns are usually discussed as an average: perhaps a portfolio earns 6% a year over a long period. That average is useful, but it does not tell you how the result unfolds. For someone who is still contributing, the order of gains and losses can matter less because new contributions buy more shares after a decline. For someone withdrawing money, the order can materially change how long the portfolio lasts.

Consider two portfolios with the same starting value and the same set of annual returns. One experiences several strong years first, followed by losses. The other suffers those losses first, then receives the strong years. If no money is added or removed, the ending value may be similar because investment returns compound. Once regular withdrawals begin, however, the investor may have to sell assets after prices have fallen. Fewer shares remain available to participate in a later recovery.

This is why sequence-of-returns risk is primarily a retirement and spending problem, not simply a measure of market volatility. A long-term average return cannot assure you that a portfolio will support withdrawals on the schedule you need.

A portfolio can have a reasonable long-run return and still fail if early losses combine with large, inflexible withdrawals.

How withdrawals turn a market decline into lasting damage

Suppose a hypothetical household starts retirement with $500,000 and withdraws $25,000 each year, adjusting the withdrawal upward over time as spending rises. If the portfolio falls 20% during the first year, its value drops to $400,000 before considering the withdrawal. After taking $25,000, only $375,000 remains invested. A later recovery must now grow a much smaller base, while additional withdrawals continue.

The same decline later in retirement may be less harmful if the household has already made several withdrawals from a larger portfolio and has fewer years of spending ahead. Timing does not make a loss pleasant, but it changes the amount of future capital exposed to the recovery.

The arithmetic is also affected by the withdrawal rate. Taking $25,000 from a $500,000 portfolio is a 5% initial withdrawal rate. Taking the same dollar amount from a portfolio reduced to $375,000 is about 6.7% of the remaining balance. If withdrawals are based on a fixed dollar amount rather than a percentage of the current portfolio, a market decline automatically makes the withdrawal rate rise.

Inflation can add pressure. A household that needs a stable standard of living may increase withdrawals even while the portfolio is down. Taxes and investment fees can further reduce the amount available, although their effect depends on the account, investments and jurisdiction. The important point is not that one particular withdrawal rate is universally safe. It is that spending flexibility, portfolio value and early returns interact.

Why the same risk looks different before and after the goal

Before retirement or another spending date, a market decline may be recoverable if the goal is far away and contributions continue. A person saving for a home purchase in eight years may have time to wait, but someone planning to use the money in eighteen months does not have the same recovery window. Time horizon determines whether a temporary decline can remain temporary for the investor's actual purpose.

For retirement, separate the portfolio into the money needed soon and the money intended for later years. Cash or high-quality short-term fixed-income holdings can cover a planned period of withdrawals, reducing the need to sell growth assets during a severe decline. This approach has a tradeoff: money held in lower-volatility assets may earn less over long periods, and inflation can reduce its purchasing power.

Another option is a flexible spending rule. Instead of increasing withdrawals automatically every year, a household might pause an increase, reduce discretionary spending or delay a large purchase after a significant decline. This can preserve shares, but it shifts some market risk into lifestyle risk. The approach works only if the budget identifies which expenses are genuinely adjustable.

Investors should also distinguish a temporary cash reserve from a portfolio that is excessively conservative. Holding many years of spending in cash may reduce short-term selling pressure, but it can create inflation and longevity concerns. Holding too little may leave the household dependent on market prices at the worst possible time. The right balance depends on essential expenses, other income, health needs and the flexibility of the goal.

Ways to manage sequence risk without trying to predict markets

No allocation can eliminate sequence-of-returns risk. The practical aim is to make a bad sequence manageable. Start by matching assets to the timing of expected withdrawals rather than treating the entire portfolio as one undifferentiated account.

• Keep near-term spending more stable. Money required in the next year or two generally should not depend entirely on selling volatile assets at an unknown price.
• Diversify the growth portion. Diversification does not prevent losses, but it can reduce dependence on one company, sector, country or type of economic outcome.
• Review the withdrawal rule. A fixed dollar withdrawal, a percentage withdrawal and a guardrail approach respond differently to falling markets. Know what would change under each method.
• Use income sources thoughtfully. Employment income, pensions, government benefits and annuity payments can cover some essential spending, reducing portfolio withdrawals. In the U.S., Social Security claiming choices may affect the plan. In Canada, CPP, OAS and employer pensions play related but distinct roles.
• Rebalance deliberately. Rebalancing can direct gains from assets that have risen toward spending reserves, but selling after a decline may be inappropriate if it merely locks in losses. Use a written target range and review schedule.
• Test difficult periods. A plan should be examined under early losses, higher inflation, longer life and unexpected expenses. The exercise is not a forecast; it exposes decisions that need to be made before pressure arrives.

Guaranteed-income products can address part of the problem by converting assets into scheduled payments, but they involve tradeoffs such as liquidity, inflation protection, insurer risk, fees and the treatment of payments after death. Compare those details with the spending need rather than assuming that any guaranteed payment is automatically suitable.

A practical review for U.S. and Canadian households

Begin with a cash-flow map. List essential and discretionary spending separately, then identify which income sources cover each category. Next, mark the dates when investments may need to fund a home purchase, education, retirement spending or a large family expense. A portfolio with one distant average horizon may be inappropriate when several withdrawals have different deadlines.

Then examine the account location. In the United States, withdrawals from traditional IRAs and many 401(k) plans generally have different tax treatment from Roth accounts and taxable brokerage accounts. In Canada, RRSP and RRIF withdrawals, TFSAs and non-registered accounts also have distinct tax rules. Do not transfer a rule from one country to the other, and confirm current requirements with a qualified tax professional.

Tax planning can influence sequence risk because selling or withdrawing from one account may create a larger tax bill than using another. A household might coordinate taxable withdrawals, tax-deferred withdrawals and tax-free withdrawals, but the best order depends on income, age, future tax expectations, government benefits and estate goals.

Finally, write down the response to a difficult first year: how much spending would be protected, which expenses could be reduced, which assets would be sold and when the plan would be reviewed. That preparation is more useful than trying to guess whether the next market year will be positive. Sequence risk cannot be scheduled away, but a portfolio and spending plan can be designed so that an unfavorable order of returns does not automatically dictate the household's choices.