Sequence of returns matters-OxBig News Network

It is normal to be concerned about the risk of negative returns (market risk) on equity investments. The impact such negative returns can have on your portfolio is related to the stage of your investing life and is referred to as the sequence of returns risk (SORR). Here, we explain SORR and discuss how you can moderate this risk.

Danger zone

A 10% decline in the market will hurt equity investments more when you are closer to retirement than when you are starting your career. This is because the equity portfolio will be large when closer to retirement. A 10% loss on ₹5 crore is significant compared with 10% loss on ₹5 lakh.

You will make annual contributions to goal-based portfolios. So, the size of portfolios will increase each year. Importantly, gains on a larger portfolio will be beneficial and losses on a smaller portfolio is preferable. So, the best sequence of returns is losses at the beginning of investment period and gains towards the end of the time horizon for a life goal. But you are exposed to the risk that your portfolio experiences positive returns during the initial period of the investment and negative returns towards the end of the time horizon for a life goal. This is SORR.

Retirees and SORR

You are exposed to SORR on all goal-based portfolios because you continually invest. As a working executive, you typically face the highest level of SORR on retirement portfolio. Retirees are also exposed to SORR because they continually withdraw money from retirement income portfolio. A portfolio that makes an initial investment without subsequent contribution or withdrawal during the investment period does not suffer from SORR; the sequence in which a 10% loss and a 10% gain occurs is irrelevant, as the end portfolio value will be the same in both scenarios.

Conclusion

The optimal way to moderate SORR is to reduce your equity investment as you approach the last five years of the time horizon for a life goal.

That said, given the size of a retirement portfolio, it is best to start reducing your equity exposure at least 10% before the retirement date.

The sale proceeds from equity must be invested in bank deposits.

You will suffer SORR on investments on which you earn capital appreciation (equity), not on interest income (bank deposits).

(The author offers training programmes for individuals to manage their personal investments)