If the sequence of returns goes awry, with negative returns following positive returns instead of the other way, it can lead to failure of achieving your life goals. This risk is greatest for individuals who have retired or are nearing retirement. But even during your working life, you are exposed to the sequence of return risk (SORR), as we discuss in this article. We also discuss how to moderate this risk.

Revisiting SORR The geometric return on the Nifty Index between January and September 2014 was 27 per cent. Suppose you only made a lumpsum investment of ₹10 lakh in January, your portfolio was worth ₹12.73 lakh by September end.

But what if you made monthly contributions as well? Suppose you invested lumpsum amount of ₹10 lakh and made monthly contribution of ₹50,000, your portfolio value was worth ₹17.91 lakh by September end.

Now, what if the returns sequence was reversed? That is, your portfolio experienced September’s negative returns in January, August’s positive returns in February and so on?

Your portfolio value would have been ₹17.88 lakh. This is because your overall returns are now determined also by the returns in each period when the contributions are made.

You may wonder if the difference is significant at all. Two factors are worth considering. One, the returns sequence is just for nine months.

And two, the market was primarily trending upwards during this period. So, changing the order of returns did not change the returns significantly.

But if you were to look at the returns sequence for five years and more, your portfolio returns can change significantly.

Your portfolio is exposed to SORR because you make investments on a periodic basis during your working life.

As the example above shows, your portfolio does not suffer SORR if you make lumpsum investment and hold it till the end of your investment horizon; the portfolio value is ₹12.73 lakh whether returns sequence changes or not.

Systematic investments Of course, lumpsum investment is not always possible, especially if you are investing to meet your child’s college education or to make a down payment for a house. In such cases, you will prefer systematic investments into the portfolio.

This is because it is easier to make monthly contributions from your salary than it is to make lump-sum investments. And whether you make systematic investments in equity mutual funds based on the fixed amount every month or fixed number of units every month, you are exposed to SORR.

You cannot reduce your equity investments as you are accumulating wealth to meet life goals; your portfolio has to contain assets that have potential for capital appreciation. Investing through lump sums subjects you to regret. What if the market declines after you invest? You may be better off choosing to moderate regret than SORR! So, you should continue systematic investments.

You can, instead, moderate SORR by investing a fixed percentage of your portfolio every month.

Under this method, you should contribute more after a period of positive returns and less after a period of negative returns.

But note that this will need you to quickly alter your amount of capital investments, and thus may be trickier to manage.

The writer is the founder of Navera Consulting. Send your queries to >portfolioideas@thehindu.co.in

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