When returns lie: The hidden risk in your portfolio

Imagine your cricket team is chasing a big target and loses 5 wickets early. Even if the middle order plays well, the team is under pressure. On the other hand, if your opening batsmen score well in the beginning, the team is not under pressure and plays with ease to chase the remaining target - the chances of winning become higher.

Let’s juxtapose this in the context of investing. Imagine 2 retirees with a similar corpus of 1 crore who begin to withdraw 5 lakh per year - 50 lakhs in 10 years.

However, at the end of 10 years, investor A has accumulated a corpus of 37.32 lakh while investor B’s portfolio grows to 58.52 lakh.


That’s an absolute difference of -36% less for Investor A. How is that possible, you might wonder.

Investor A earns:- -5%, -6%, -15%, -8%, -4%, 5%,7%,9%,11%, 9%.

Investor B earns the same returns in reverse sequence:- 9%, 11%, 9%, 7%,5%,-4%, -8%, -15%, -6%, -5%.

Investor A started investing during a bear phase while investor B began in a bull phase. Their returns are identical but in reverse order.

(Returns are for illustration purposes only. XIRR: Internal Rate of Return)

Investor A has earned a total amount of 87.32 lakh (50 lakh + 37.32 lakh) over this period while Investor B has earned 1.08 crore (50 lakh + 58.52 lakh) if we add the total withdrawal + the balance at the end of the year. Investor B has made a net positive amount of 8.52 lakh despite the 50 lakh withdrawals and five years of negative returns from 2015-2019.

Why does this happen? The timing of investing has a profound impact on the portfolio. This is because both investors are withdrawing from their savings and the amount on which these returns are generated are not the same.

For instance, Investor A’s corpus falls to 90 lakh after seeing 5% fall in the first year and 5 lakh withdrawal while Investor B’s balance increases to 1.04 crore even after withdrawing the same amount. This is because Investor B has earned 9% in the first year.

Investor B earns negative returns from sixth to tenth year but that does not have the same degree of impact on the final portfolio.

Investor A experiences negative returns in the first five years while she continues to withdraw 5 lakh each year. The combination of negative returns and withdrawals has a snowball effect on the final portfolio value for A.

This shows how the sequence of returns can have an impact on portfolios, especially for retirees who have to rely on a single source of income. While this concept is correct theoretically, timing the market is difficult for anyone to get the best outcome.

Retirees, especially those who are at 60 still have 15-20 years of investment horizon. Thus, planning by factoring the sequence of return risk for a long investment journey becomes crucial.

Historically, the Sensex has witnessed two consecutive yearly declines during 1986-87, 1995-96 and 2000-01. However, if we dig more granular data (monthly or daily returns), you will encounter negative consecutive returns quite often. (Source: BSE)

Investors can plan to mitigate such risk with the help of bucketing approach (spreading the corpus into three different buckets like short term (fixed income portfolio), medium term (hybrid), and long term (equity) and building a secondary income, which can act as a buffer during volatile markets, which we have discussed earlier here.

Alternatively, investors can reduce their withdrawal rate, buy a fixed annuity or include assets like debt, gold, REITs and international assets to diversify and possibly reduce the downside volatility.

Sequence of return is an important factor to consider while building portfolios for deploying lumpsum in markets and especially when you are withdrawing from the corpus.

Just as early success in chasing a big target in cricket increases the probability of winning, the sequence of positive returns in the initial investment journey can impact the final score/value of your portfolio while investing lumpsum. Volatility is an inherent part of equity markets and investors would be able to navigate it better with the guidance of a trusted advisor.

(The author is CEO, PGIM India MF)

(Disclaimer: Recommendations, suggestions, views, and opinions given by experts are their own. These do not represent the views of the Economic Times)