The Art of Managing Sequencing Risk

The Art of Managing Sequencing Risk

The equity market is full of uncertainties and many analysts are still not able to comprehend the level at which equity indices and companies’ shares are trading currently. Many valuation matrices are showing signs of exaggeration. The sudden and sharp movement in the equity market can put even the best professional investors in a tight spot. For instance, last year, though the corona virus was detected in the month of November 2019, the equity market globally kept on moving higher only to fall by almost 40 per cent in just a couple of months in the months of February and March. This led to a deep cut in the value of investors’ portfolios.

At such times, managing risk is one of the crucial aspects of investment. We see a lot of investors focusing only on returns and ignoring the risk part, which either leads to disastrous results or a devastating investment experience. Such a scenario often results in investors moving out of a particular investment or asset class forever. Does this imply that investing in such an asset class was a bad decision? Not at all! The only thing gone wrong is the underestimation of risk associated with that asset.

Sequence Risk
Sequence risk or sequence-of-returns risk is one of the most under-appreciated risks in investing. We will explain this with the following example. If you start with a portfolio value of Rs24 lakhs and withdraw Rs2.4 lakhs every year (at the end of the year) and earn total returns of 10 per cent in the first year, 10 per cent the next year and negative 10 per cent the third year, you would end up with Rs19.2 lakhs by the end of the third year. The following table shows the movement of your portfolio.

When we reverse the sequence of returns, everything else remains the same. So you will again start with the same amount of portfolio, will withdraw the same percentage every year but the sequence of returns reverses. The following table shows the movement of your portfolio with reversing of the return sequence. 

You can see that as returns happen in the reverse order, you would end up with just Rs18.19 lakhs, as shown above. Since the negative return happ ens at the beginning of the period when your portfolio has a higher value, it carries more weight in the overall results. So a negative return will have an impact on your portfolio. At the same time, the portfolio doesn’t benefit as much in rupee terms from the two years of positive returns because there are fewer rupees remaining to grow. Moreover, you need to earn higher to cover up the losses. For example, if the portfolio of Rs100 falls by 50 per cent, it has to rise by 100 per cent to reach its original value.

Sequence of Returns and Portfolio Value
Empirically, the Indian equity market represented by the Sensex has had very few instances of sequence of continuous 2-3 years of negative returns in the last 41 years. There are only three instances when the Sensex generated negative returns for two years in a row. 

Nevertheless, any event such as a global financial crisis or the pandemic that took root last year can wreak havoc on the portfolio of investors, especially those who are heading into retirement or are in retirement and have a majority of their portfolio parked in stocks. The following example will help you to understand the hardship of Raj Sharma who retired with an all-equity portfolio in 2008 just as the market was heading into one of the worst performances of recent times. We have assumed that Sharma retired at age 60 with a portfolio worth Rs24 lakhs. With an annual withdrawal of Rs2.4 lakhs which increases by 4 per cent every year to keep up with inflation, the portfolio’s value would have diminished by more than 50 per cent by the first year itself. As a result, the portfolio didn’t benefit as much as expected from the market’s rebound in 2009 when the market generated 81 per cent return. Adding insult to injury, the portfolio would have suffered another major blow when the market dropped about 25 per cent in 2011.

The above table shows the value of the portfolio at the year end. By the age of 67 the retiree would have been left with nothing in his portfolio. In seven years he would have withdrawn only Rs21.86 lakhs. Now consider another case when the returns are reversed i.e. the returns for 2008 would have been negative 5 per cent while returns for 2015 would have been negative 52 per cent. The following table shows the portfolio movement of Sharma when the returns are reversed.

It clearly shows that his retirement fund would have supported him for four more years.

Avoiding Sequence Risk

You cannot completely avoid the risk associated with invest-ment and hence its management becomes an integral part of investing. So, how do you reduce the impact of sequence risk? There are two things that you need to keep in mind. First, while calculating the corpus it is better to assume even the worst case scenario. This means that you need to assume that your retirement phase would start with a bear market and then calculate the corpus accordingly. Also, while investing for corpus accumulation you need to account for the impact of sequencing risk.

The first thing that you have to keep in mind is the need to diversify your portfolio and have a majority of the investments in fixed income securities or debt funds. It does not mean that debt funds are risk-free; however, returns typically fall in a smaller range and can help buffer some of the risk of an equity market downturn. So anyone retiring right before the fall of year 2008 would have fared much better with a balanced portfolio of 60 per cent in bonds and 40 per cent in stocks with annual rebalancing. In 2008 the debt fund represented by CRISIL Composite Bond Fund Index generated return of around 9 per cent.

If Sharma would have maintained a ratio of 40:60 in equity and debt, respectively, we see that his retirement fund would have lasted for a much longer time. The following graph shows the movement of his retirement corpus. Even at the end of 2021 he would have been sitting on a corpus of more than Rs4 lakhs. 

Secondly, in the retirement phase, adopt a bucket investment strategy. With this you need to create three buckets. The first should be where you are conservative with investments – pri-marily in debt mutual funds. The second bucket should be a mix of equity and debt and the final bucket should be more inclined towards equity investments as the money required is still 20 years away. The conservative bucket would help you have a streamlined cash flow. The second bucket would help you to get better inflation-adjusted returns and the third bucket would help you to grow your money over the long term.

As you complete the first 10 years, move all the money from the second bucket to the first bucket and from the third to the second bucket. This strategy would help you to reduce the impact of sequencing risk to a great extent. As the retirement phase is a very conservative phase with no or minimal income, your sequencing risk should have the ability to not disturb your cash flows and turn negative. Therefore, it is important not to ignore the impact of sequencing risk on your investments, specifically those with a longer time horizon such as retirement. Understanding how it works can go a long way towards making sure your portfolio isn’t overly exposed to the potential downside.

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