Risk is an ever present and unavoidable truth when it comes to investing. Today, most of us are well aware of most forms of risk that our investments are exposed to. Some of these forms of risk are manageable or even completely avoidable. Others we just have to live with and work around, since they are unavoidable. But there is one form of risk that most of us would be unaware of, even though it is quite significant. This form of risk is of great importance to those who follow a goal based approach to their investing. This is because the form of risk I'm talking about can have a significant impact on our chances of successfully achieving our major financial goals. I'm talking about sequence of returns risk, more commonly known as sequence risk.
Sequence risk is usually silent and only shows up once in a while. But if it were to show up at the wrong time, there is a chance of our financial plans being completely derailed and all our hard earned returns until that point being wiped out. So today I will be talking about what sequence of returns risk is, how it works, why it is dangerous and how we can work around it.
In the most basic sense, sequence of returns risk is the risk of our portfolios experiencing a sudden and severe drop in value (technically called a portfolio drawdown) after a few years of sustained positive returns. Quite obviously, sequence risk can affect any portfolio and any asset class. Let us first take a look at sequence risk in action to understand how it works. Assume that I invest Rs 100 today. The returns and final values from the first five years are given in the graphic that follows.
After a steady sequence 4 years with returns at the rate of 10%, the value of my investments fall by 20% in the 5th year. Now here's the scary part. In year 6 I would need a return of 25%, just for the value of my investments to come back to where they were before the drop in year 5 (117.128 + 25% = 146.41). And a return of 25% in a single year is not something that we can realistically afford to expect, especially with multi asset portfolios. Clearly, while a drop in our portfolios is mostly sudden, recovery would almost always take time.
And this is exactly why sequence risk is dangerous when planning for our financial goals. Suffering a portfolio drawdown in say year 7 or 8 of a 15 year goal is relatively manageable, since we still have some time left to allow our portfolios to recover. But suffering a drawdown between years 12 to 14 would make things extremely dicey. In such a case because the drawdown occurs so close to the deadline of the goal, there would be little time if any for our portfolios to recover. Therefore, our plans would have to change drastically to try and salvage the situation.
Another point to be kept in mind. In the example I previously illustrated, I assumed an investment of Rs 100 and a drawdown of 20% for ease of calculation and understanding. But things in the real world would be quite different. Firstly, we would be investing a lot more than just Rs 100. Also, a drawdown in the real world can be can be as high as 50% (portfolios actually experienced such drawdowns during the Global Financial Crisis in 2008) or more. And a 50% drawdown would require a 100% increase in value for a full recovery. But it is very rare for such increases to happen in a short span of time.
These are just the technical and numerical aspects of the problem. There are also a few practical aspects we need to consider. Firstly, portfolio drawdowns do not always last for exactly a year. There may be a situation where our portfolios drop today, stay stagnant for a couple of years and then enter the phase of recovery. Because of this, there is a very real possibility of us losing more time than we can afford to. This would increase the degree of dependence placed on the returns generated by our portfolios. This effectively means that our chances of achieving our financial goals would heavily depend on a variable that is completely out of our control.
We must also consider the constraints placed by the nature of our financial goals. Time lines set for aspirational goals such as buying a new home, a new vehicle or going on vacation are more flexible and can therefore be shifted to a reasonable extent. Sequence risk is therefore not such a crucial factor in the case of such goals. But essential goals such as planning for retirement or our children’s education do not provide this luxury. In the case of such goals strict adherence to time lines is necessary. Therefore, we cannot afford a portfolio drawdown in year 12 or 13 when creating a retirement corpus or college fund that would be due after 15 years.
If this were to happen, we would have little choice other than to postpone retirement or pause our children’s education for a few years. Both these scenarios would be extremely upsetting at an emotional level, and must therefore be avoided as possible. More specifically in the case of retirement planning, managing sequence risk becomes slightly more challenging. This is because increasing life expectancies mean that our money would have to last us for longer. Therefore, when planning for retirement we must factor in longevity risk over and above sequence risk.
Sequence risk needs to be constantly and proactively managed. There are two main ways in which this can be done. The first of them is regular portfolio rebalancing (at least once every 18-24 months). Sequence risk tends to hit portfolios that are lopsided or out of balance harder than others. Regular rebalancing definitely moderates returns. But more importantly, it also ensures that our portfolios are not overly exposed to any product or asset class. This means portfolio risk, and thereby the ill effects of potential drawdowns are also moderated.
Reducing the equity allocation in the preset asset allocation strategy for each goal is key to managing sequence risk. This is especially true in the case of long term essential goals such retirement planning and setting up a college fund. The allocation to equity may be reduced at agreed intervals say once every 5 years. As our goals come closer, the objective should be to have as much of our money in relatively safe avenues as possible. This can be better understood by looking at the graphic that follows.
As can be seen clearly, the asset allocation of this retirement portfolio is reduced from 60-40 in favour of equity to 90-10 in favour of debt over a span of 15 years. Reducing the equity allocation of a portfolio involves resetting the fundamental asset allocation of the portfolio. Rebalancing the portfolio just ensures that we stick to the chosen asset allocation strategy without changing it. So, it must be borne in mind that the two are not synonymous.
Also, while rebalancing our portfolios reduces the damage caused to our portfolios by a drawdown, reducing the equity allocation and shifting our money to safer assets allows us to progressively lock in the gains we have accumulated over the years. Therefore, it is vital for us to carry out both exercises in parallel to be able to guard our portfolios against sequence risk. Manging all forms of risk is vital to ensuring that our portfolios generate satisfactory, stable and sustainable returns.
And this is no different in the case of sequence risk. Though it remains silent most of the time, the repercussions when it does strike are almost always irreversible. Therefore, the most sensible way to deal with sequence risk would be to constantly do enough to prevent its harmful effects rather than looking to manage its after effects once the event has occurred.