The Nifty index has moved nearly 10 per cent since mid-November 2012. Many investors, therefore, fear that asset prices can decline just as sharply in the near future. Indeed, such asset price volatility is not good for your investment portfolio. In this article, we discuss the risk that you face in your retirement portfolio or your retirement income portfolio because of such volatility and how you can moderate these risks.
The biggest risk you face in your retirement portfolio is the shortfall risk (the risk that you will fall short of accumulating the required wealth at retirement). You could face shortfall risk due to variance drain. The term ‘drain’ refers to the fact that an active portfolio will generate variance in excess of its passive alternative. This is because an active fund has to deviate from its benchmark index to generate the excess return. This variability in returns could result in your portfolio’s geometric return to be lower than its arithmetic returns.
Suppose your portfolio generates a 15 per cent loss in one year and a 15 per cent gain the next year. The arithmetic return is zero but the geometric return is -2.25 per cent. The variance drain is -2.25 per cent, the difference between the arithmetic and geometric returns.
Variance drain is important because it affects the terminal value of your portfolio. Higher the variance drain, lower the amount of money you have in your portfolio at retirement. You could reduce your variance drain in two ways. One, you could buy a combination of index funds in India and low-volatility ETFs in the US for your equity investments and bank fixed deposits for your bond investments. And two, you could reduce your equity investments between age 45 and your retirement date such that you have more bond investments at retirement.
If you are a retiree and have a retirement income portfolio, you face longevity risk (the risk that you will outlive your investments).
You are exposed to longevity risk because of sequencing of returns risk. Suppose you have Rs 10 crore in your retirement income portfolio and you suffer a loss of 15 per cent in one year and gain 15 per cent in the next year. Further suppose you withdraw Rs 5 lakh each year for your lifestyle requirements. Your portfolio will be down by Rs 33.25 lakh by the end of the second year. Instead, suppose your portfolio gains 15 per cent in first year and loses 15 per cent the next year. Adjusting for the withdrawal of Rs 5 lakh in both years, your portfolio will be down by only Rs 31.75 lakh. Clearly, it matters which comes first, losses or gains. This is because you withdraw money from your portfolio every year.
You can moderate the sequencing of returns risk by creating an emergency fund. You can use this fund to finance your living expenses during years when your equity investments suffer losses. The emergency fund should have at least 12 times your living expenses, adjusted for inflation. To further reduce your risk, you can also consider funding your living expenses through stable income sources such as annuities. This will moderate your need to withdraw cash periodically from your equity-bond investment portfolio.
cost of variance drain
If you are working, your objective is to reduce the cost of variance drain on your retirement portfolio. If you are a retiree, your objective is to moderate the sequencing of returns risk on your retirement income portfolio. In either case, your ability to manage risk is important to achieve your objective. These risks suggest that it is better to invest in products that offer low but stable returns than to invest in products that offer high but variable returns.