Risk is an unavoidable truth in investing. Most of us are aware of the major 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. But there is one very significant form of risk that most of us would be unaware of. 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 returns being wiped out. So today I will be talking in detail about sequence of returns risk. I will talk about what it is and how it works. I will then show why it is dangerous and how we can work around it.
Sequence of returns risk is born from the unpredictability of investment returns. It is the risk of a sudden and severe drop in the value of our portfolios. This is technically called a portfolio drawdown. Portfolio drawdowns are particularly dangerous when they occur right around the time our financial goals fall due. This implies that sequence risk does not stem from the amount of returns that accrue to our portfolios.
It rather stems from the pattern in which our returns accrue. Sequence risk majorly affects portfolios for long term goals. Such portfolios usually have a significant exposure to growth oriented assets. Returns from such assets can be highly volatile. And volatility is one of the major drivers of sequence risk.
Let us look at an example 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 of 4 years where my portfolio grows at 8%, my portfolio falls by 20% year 5. Now here's the challenging part. In year 6 I would need a return of 25%, for my investments to come back to where they were before the drop (108.8391+ 25% = 136.0489). Our portfolios are usually a mix of risky and safe asset classes.
The presence of safe asset classes in the portfolio reduces its expected returns. So a portfolio return of 25% in a single year is not something that we can realistically expect. This shows that while a drawdown is sudden, the recovery would almost always take time. Most investors cannot psychologically handle severe drawdowns. This does not allow them to wait through the subsequent period of recovery.
This is severely detrimental to investors' prospects of sticking to their financial plans and achieving their goals. The second major source of sequence risk is the timing of the drawdown. Portfolio drawdowns can sometimes hit investors at exactly the wrong time. Suffering a drawdown in say year 7 or 8 of a 20 year goal is quite manageable. There would still be enough time to allow the portfolio to recover. But suffering a drawdown in say year 17 or 18 would make things extremely dicey. Here the drawdown occurs very close to the deadline of the goal. So there would be little time if any for the portfolio to recover. Therefore, the investor’s 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 means that our chances of achieving our goals would depend on a variable that is uncontrollable.
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. They can therefore be shifted into the future. 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 timelines is necessary. Therefore, we cannot afford a portfolio drawdown in year 17 or 18 when creating a retirement corpus or college fund that would be due after 20 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. They must therefore be avoided as far as possible. Sequence risk must therefore be constantly and proactively managed. Strategies to manage sequence risk would depend on the type of long term goal in question.
For any goal apart from retirement planning, there are two main ways to manage sequence risk. The first of them is timely portfolio rebalancing. Sequence risk tends to hit portfolios that are lopsided or out of balance harder than others. Regular rebalancing 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 is reduced, 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 100% 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.
In the case of retirement planning, managing sequence risk becomes slightly more challenging. This is especially true for the post retirement phase. 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.
Regular rebalancing and reduction of the equity allocation would largely be sufficient to manage sequence risk during the accumulation phase. But the exercise of managing sequence risk post retirement is a completely different ball game. There are specific strategies that are prescribed to manage sequence risk during the post retirement phase. I will discuss them and wrap up the discussion on sequence risk in a separate blog post that will be released next week.
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