Why order matters in returns :: Business Line

A capital loss of 5 per cent will hurt. But the effect will depend on whether this loss precedes or follows a 10 per cent gain.

Three factors determine whether you will achieve your life goals. First is your disciplined approach to savings. Second is your choice of investment products. And third is your portfolio’s return experience.

In this article, we discuss how your portfolio’s returns experience in each period, called the sequence of returns risk (SORR), can affect your life goals and how you can moderate this risk.

Understanding SORR

Suppose, your initial investment capital was Rs 5 lakh and your contribution was Rs 50,000 every month between December 2012 and 2013.

Based on the actual returns on the Nifty Index, your portfolio would have accumulated Rs 11,85,288 by December 2013. But what if the order of returns-experience were changed?

Assuming the same initial capital and monthly contribution, if the monthly returns on the Nifty Index were reversed (if December 2013 returns were actually experienced in December 2012 and likewise for the rest of the months), your portfolio would have accumulated Rs 11,49,918.

We also arranged the monthly index returns from the lowest to the highest returns and vice-versa. If your portfolio suffered all negative returns first and all positive returns later during this 13-month period, your portfolio would have accumulated Rs 12,57,956 by December 2013. But if you earned all positive returns first and negative returns later, your portfolio would have been 14 per cent lower at Rs 10,88,709.

This exercise shows that your portfolio wealth depends on the order of your returns-experience. Imagine the effect on your portfolio when your investment horizon is 30 years!

The risk that you will fail to achieve your life goals because the order of returns-experience could affect your portfolio wealth is called SORR. You run this risk whether you contribute capital or withdraw capital from your investment portfolio. SORR, thus, affects both working professionals and retirees.

Moderating SORR

Your portfolio size will be large as you approach retirement. And that is when your portfolio is even more vulnerable to the sequence of returns-experience. You can moderate SORR by reducing your equity investments as you enter your working-life side of the retirement risk zone –— the 10 years approaching your retirement.

Note that a typical portfolio will contain about 25 per cent equity investment at retirement. You can, therefore, only moderate and not eliminate SORR. What if you fail to accumulate the required wealth at retirement despite moderating SORR?

Typically, you may have to resort to one of the two choices; you can defer your retirement date if possible or reduce your post-retirement consumption. But you can also morph part of your retirement portfolio into your retirement income portfolio and retire without reducing your living expenses (for more details, read “Bridging shortfall in retirement portfolio” that appeared in this column dated September 22, 2013).

But what if you are already retired? You run high SORR especially during the 10 years immediately after retirement – the retired-life side of the retirement risk zone. You should keep your equity investments to a minimum during this 10-year period.

You will be exposed to SORR only if you withdraw cash from your equity portfolio. So, one way to reduce your SORR is to have stable cash-flow products, such as annuity (preferably) or bank fixed deposits to fund your monthly living expenses.

Conclusion

You will be exposed to SORR whether you are a working professional or a retiree. Only those contributing lump-sum money and holding their portfolio through the investment horizon do not suffer from SORR.

Note that SORR is not market risk. Market risk is the risk that your portfolio will decline with the market. SORR is the risk that the order of returns may hurt your portfolio value – whether your portfolio experiences, say, 5 per cent loss first and 10 per cent gain next or the other way.

Investing is, indeed, uncertain!

��

-->