What is sequencing risk all about?
At a broader level there are two types of risks that potentially affect your investments: systematic and unsystematic risk. Systematic risk is also referred to as market risk which is non-diversifiable and you will have to bear it as the market falls. Unsystematic risk is something which is an inherent part of any investment. This can be contained and controlled by further diversification. However, one cannot get rid of it. And when you manage your personal finance, an additional risk gets associated – that of not achieving your financial goals.
This can be exemplified in the current situation when an investor with his retirement corpus in equity suddenly sees a yawning hole in his retirement fund. If he would have been in the accumulation phase where he is contributing to his retirement fund and his income growth is quite impressive, then he would probably be able manage this risk. However, if there is no adequate income growth in the accumulation phase or he is in a distribution phase where he is withdrawing funds from the retirement corpus with minimal or low income, then in that case this risk can serve a violent blow to his retirement planning.
What is sequencing risk?
Technically, this risk can be denoted as sequence risk or sequence of returns risk. With the recent turmoil in domestic as well as the global financial markets, many an investor might be facing challenges with respect to retirement income. And even though many believe that timing the market is not an ideal thing, in our opinion, the time you enter and the time you exit the market is indeed crucial. The timing of poor market returns, also known as sequencing risk, can have a significant impact on investment outcomes. This type of risk is specifically more challenging for retired individuals as they have minimal to low income to cope with the changes in the market dynamics.
Sequencing risk is where the order and timing of investment returns are unfavourable, which results in less money for the retirement corpus. To understand this better, let us go through an illustration. Consider two scenarios. In the first scenario we assume that you had invested Rs 50 crore in S&P BSE Sensex at the start of April 1990 and remain invested till March 2020. You get the actual returns. In the second scenario, we would just inverse the returns starting from March 2020 to April 1990, keeping the investment amount the same. The graph below shows the actual movement of your fund in these two scenarios.
As can be seen from the above graph, an investment of Rs 5 crore in both the scenarios at the end would accumulate to Rs 1.88 lakh crore. However, the journey is different in both the cases. In the first scenario, you started off with the bull phase but in the second scenario you started off with the bear phase. You may argue that it does not matter if at the end you are getting the same accumulated amount. True, because in an accumulation phase this doesn’t matter. The reason is that you are not withdrawing from your investments but allowing them to grow till the end. However, when it comes to the distribution phase, you would be withdrawing irrespective of market conditions. Therefore, there is a possibility that in the second scenario you may see your investment fund dwindling in the initial years and you would outlive your retirement corpus.