Managing The Sequence of Returns Risk

The equity market is fraught with uncertainty, and many experts are still unable to fathom the present level at which equity indices and stocks trade. Many valuation matrices appear to be exaggerated. Even the finest skilled investors might be caught off-guard by the quick and rapid fluctuation in the stock market. For example, despite the discovery of corona virus in November 2019, equity markets throughout the world continued to rise, only to plummet by about 40 per cent in February and March 2020. This resulted in a significant decrease in the value of investors’ portfolios. 

Managing risk is one of the most important parts of investing at this time. We have seen that many investors are just focused on the return and neglect the risk that a specific investment entails. This frequently leads to a bad consequence or a disastrous investing experience. In such cases, investors often exit a specific investment or asset class for good. Is this to say that investing in such an asset class was a terrible idea? Absolutely not! The sole mistake was underestimating the inherent risk with that asset. One of the most commonly disregarded risks is the risk of sequence of returns.

Defining Sequence of Returns Risk

One of the most underrated risks in investing is sequence risk, often known as sequence of returns risk. Furthermore, this risk is more visible in retirement. Let us look at an example to better grasp this. Assume you begin with a portfolio of ₹25 lakhs and withdraw ₹2.5 lakhs at the end of each year for the next five years. Furthermore, assume you get total returns of 10 per cent in the first year, 12 per cent in the second year, 14 per cent in the third year, 16 per cent in the fourth year and negative 20 per cent in the fifth year. With this, you would have ₹20.16 lakh at the end of the fifth year.

What if we change nothing else but flip the order of returns? Assuming the same starting investment, and withdrawing the same proportion each year, the sequence of returns is reversed. 

As seen in the table above, reversing the order of the returns will result in ₹16.67 lakhs in your hands. Given that your initial investment was bigger at first followed by a year of negative return, it will lower your original investment while increasing the total impact. The portfolio, however, doesn’t gain much in rupee terms from the four years of good returns since there are fewer rupees left to increase. Furthermore, you must earn more to compensate for your losses. For example, if a portfolio of ₹100 falls by 50 per cent, it must climb by 100 per cent to regain its original value.

Understanding Sequence of Returns with Sensex

In the past 42 years, the Indian stock market, as represented by S&P BSE Sensex, has seen relatively few instances of a sequence of back-to-back two to three years of negative returns. Only three times in history has the S&P BSE Sensex returned negative returns for two consecutive years.

Nonetheless, any incident such as a global financial crisis or a pandemic that occurred in 2020 might devastate an investor’s portfolio. This is especially true for people who are approaching or are in retirement and have the majority of their assets invested in equities. Ranjeet Bhatia’s tale will help you comprehend the difficulties he endured throughout his retirement. Bhatia retired with an all-equity portfolio in 2008, just as the market was about to have one of its worst years in recent history. Bhatia retired at the age of 60 with a portfolio of ₹25 lakhs. His yearly withdrawal was ₹2.5 lakhs, which increased by 6 per cent each year to keep up with inflation.

Bhatia’s cash flows in retirement are depicted in the table above. In the first year, the value of his portfolio fell by more than 50 per cent. However, the market’s performance in 2009 was astounding, with a return of more than 81 per cent. Yet, the value of Bhatia’s portfolio did not increase as anticipated. The performance of the equity markets in 2011 when Sensex fell roughly 26 per cent exacerbated the misery. This was just another setback for Bhatia’s portfolio. By the time Bhatia reaches the age of 67, he will have nothing in his portfolio. He would have withdrawn close to ₹24.74 lakhs in the first seven years. 

Consider another instance in which the returns are reversed. This means that the returns in 2008 would have been negative 5 per cent, while the returns in 2015 would have been negative 52 per cent. The table above shows that when the sequence of the Sensex’s yearly returns is reversed, the outcomes are considerably different. Bhatia still has money left over after reversing the sequence when he approaches the age of 67. In the first situation, this was not the case. In fact, he has the option of withdrawing for an additional two years until he outlives his corpus.

Handling Sequence of Returns Risk

Even while you cannot completely eliminate the risk involved in investments, you can manage it effectively. As a result, risk management is critical while investing. So, how can you deal with and mitigate the impact of sequence of returns risk? There are four approaches to dealing with sequence of returns risk.

1) Lowering Withdrawal Rate ― In this case, lowering your living style or standards may allow you to withdraw less and therefore extend the life of your corpus. There are those that adhere to the 4 per cent rule. Various studies on the subject reveal that historically a 4 per cent distribution of the initial corpus adjusted for inflation may be maintained for 30 years. Furthermore, when you diversify into small size or overseas assets and maybe increase your equity exposure to more than 50 per cent, this figure improves.

On the other side, there are a few research findings that show the 4 per cent rule might not work in the future. So, what should you do in such a situation? To make money last longer, you might adopt a conservative strategy and maintain your withdrawal rate at 2.5 per cent or 3 per cent. You might also try altering the withdrawal amount based on market conditions. While the markets are unfavourable, you may want to consider withdrawing lower.

2) Income Laddering ― Another strategy for mitigating sequence of returns risk is to generate income from non-market sources. This entails implementing a bond ladder method, which generates cash flow and more dependable income than the equity market. Bond income laddering involves taking money from an investment portfolio and investing it in bonds that mature over a certain number of years. Assume you wish to purchase five years of income. You may then go out and buy five different bonds to cover your income for the following five years.

The first bond would mature after a year, the second after two, the third after three, the fourth after four, and the last one after five. At that time, your income for the following five years is set, and you don’t need to worry about spending from your investment portfolio. A term annuity might be used as an alternative to a bond ladder. A term annuity might be purchased to provide income over a certain time period. An annuity is a fixed amount of money that you will get each year for the rest of your life.

3) Cash Reserve Bucketing Strategy ― The 1980s and 1990s saw the growth of the ‘bucketing’ approach to budgeting retirement income. According to the bucketing strategy, assets are divided into money buckets for distinct time periods. You reserve more conservative assets for short-term requirements such as cash, mixed investment portfolios for the following time period and equities for the long term. Some people elect to keep one to two years of cash in order to satisfy their retirement spending demands.

If the market has a significant downturn, they can spend their cash for two years to ride out the slump while their equity investments rebound. You should keep two things in mind. To begin, while computing the corpus it is best to consider the worst-case situation. This implies you must anticipate your retirement period will begin with a bear market and then calculate the corpus accordingly. Furthermore, while investing for corpus accumulation, you must consider the influence of sequencing risk.

4) 40:60 Portfolio Strategy ― It is critical to realise that you must diversify your portfolio in such a way that neither too much risk nor too much gain is sacrificed. To do this, you must have a portfolio that is heavily weighted toward fixed income securities or Debt Funds. We are talking about a portfolio in the ratio of 40:60. This implies that you would be investing 40 per cent of your corpus in equities and 60 per cent in debt. One thing to keep in mind is that the notion that debt funds are risk-free is fiction. Even while their returns are declining, they do so more slowly than equities do. This might also assist to protect your investments when the equity markets are falling.

So, if someone had retired immediately before the 2008 market crash, their portfolio with a 40:60 allocation would have done significantly better in terms of yearly rebalancing. The debt fund represented by the CCIL All Sovereign Bonds Total Returns Index (TRI) earned a return of around 24.27 per cent in 2008. If Bhatia had kept a ratio of 40:60 in equity and debt, we can see that his retirement money would have lasted much longer. The graph (Retirement Cashflow of a 40:60 Equity-Debt Portfolio) depicts the movement of his retirement corpus.

Conclusion

When it comes to optimising cash flows, the retirement phase is critical. When your investment returns decline and inflation rises, this becomes much more challenging. As a result, it is critical to consider the risk of the sequence of returns. Accounting for this risk might typically lead to a more cautious strategy. This will also assist you in creating a retirement corpus while considering the worst-case situation and maintaining a buffer to support your living style. A bucket investment plan is a more prudent method. You would be designing three buckets here.

The first bucket is more cautious with investments focused mostly on debt mutual funds. The second bucket should have a reasonable balance of debt and equity. This might be the previously suggested 40:60 equity-debt portfolio. Because the funds required are still 20 years away, the last bucket should be more oriented toward equity investments. The cautious bucket would aid in streamlining your cash flow. The second bucket would assist you in obtaining greater inflation-adjusted returns.

And the last bucket would assist you in growing your money over time so that you never run out of corpus. This method has a significant influence on decreasing the impact of sequencing risk. Because retirement is a cautious period with little to no income, sequencing risk should not disrupt your cash flows and cause them to turn negative. As a result, neglecting the influence of sequencing risk on your investments would most certainly burn your corpus, particularly those with long-term distributions, such as retirement.