Personal Finance

Why sequence of return matters

B Venkatesh | Updated on January 23, 2018

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Move away from equities as you near your investment horizon to mitigate market risk

Systematic investment process creates a disciplined approach to savings. But systematic investments in risky assets, such as equity, expose you to a unique risk called sequence of returns risk (SORR).

Typically, SORR is discussed with reference to retirees who withdraw money from their portfolios to sustain their post-retirement lifestyle. In this article, we discuss why one is exposed to SORR even during the wealth accumulation phase and why it is difficult to manage this risk.

Periodic contributions

SORR is the risk that your portfolio value will be different because of the sequence in which your portfolio experiences returns. Suppose your portfolio gained 5 per cent in the first period and declined 5 per cent in the next period and your capital contribution is ₹10,000 in both these periods. Your portfolio value at the end of the second period will be ₹19,475. If, however, your portfolio declined 5 per cent in the first period and gained 5 per cent in the second period, your portfolio value will be ₹20,475.

Think of SORR as an unpredictable returns experience that can harm your life goals. You are subject to SORR only when you make periodic investments in your equity portfolio.

If you make a lumpsum investment of ₹20,000 at the beginning of the first period, your portfolio value will be ₹19,950 irrespective of whether you gain or lose 5 per cent first. Yet, making lumpsum investment is not always feasible. So, can you moderate SORR while making systematic investment?

The answer depends on the distance to investment horizon. Your portfolio is subject to high SORR when you are close to the end of your investment horizon. Why? Your portfolio value will be large at that point in time. Even small negative returns can lead to large losses and cause shortfall in your target value needed to achieve your life goal. You can reduce SORR by moving from equity investments to bank fixed deposits when you are five years away from the end of your investment horizon.

But you cannot de-risk your portfolio by investing more in bank deposits at the beginning of the investment horizon; for that would mean larger capital contribution to achieve the same target value, as expected post-tax returns on deposits are lower than the expected return on equity.

Procedural hassle

Some experts recommend you adopt value averaging to reduce SORR. Suffice to know that in value averaging, you invest more when the markets are down and less when the markets are up to catch-up with the target value. But this approach does not reduce SORR; it simply bridges the shortfall caused due to SORR by increasing the monthly contributions when market returns are lower than the required returns to meet a life goal.

Besides, your monthly contributions will depend on the market movements. This could be a problem if you are pursuing multiple life goals and prefer to set aside a fixed sum to invest each month. Then, there is the problem of mechanically implementing this process. All mutual fund companies offer systematic investment plans; only few offer value-averaging plans.

Bottomline: You have to assume SORR during the initial years of your time horizon for a particular goal. But you can moderate SORR by reducing equity investments as you near the end of your time horizon for a goal. For most part of your wealth-accumulation phase, you have to assume this risk when you invest in equity or any risky asset. You can reduce SORR only by making lumpsum investments.

The writer is the founder of Navera Consulting. Feedback may be sent to portfolioideas@thehindu.co.in

Published on October 18, 2015

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