The Hidden Danger in Your Investment Returns
Most investors focus on average returns when planning their financial future. They assume that if two portfolios earn the same average return over time, they will end up with identical values. This assumption, however, overlooks a critical factor that can dramatically alter long-term wealth outcomes.
Understanding Sequence of Returns Risk
The order in which investment returns arrive matters significantly. This phenomenon is known as sequence of returns risk. It becomes particularly relevant during periods when investors are actively adding to or withdrawing from their portfolios, rather than simply holding a lump sum investment.
Consider this simple example with two investors who both earn an average annual return of 10% over four years.
- Investor A experiences returns in this order: +20%, +15%, –10%, –5%
- Investor B experiences returns in this order: –10%, –5%, +20%, +15%
If both investors put in a lump sum and make no additional investments or withdrawals, their final outcomes might be similar. However, the situation changes completely when investments happen over time through systematic investment plans.
How SIPs Interact with Return Sequences
When you invest ₹1 lakh every year through a systematic investment plan, the sequence of returns creates different outcomes. If the initial years deliver poor returns, your portfolio value remains depressed for longer. Subsequent positive returns then compound on a smaller base, meaning you need significantly higher returns just to catch up to where you could have been.
In contrast, if strong returns come early in your investment journey, your portfolio grows faster. Future gains then build on a much larger base, creating a compounding advantage that can last for decades.
During accumulation phases, sequence risk becomes less critical because SIPs enable rupee-cost averaging. This strategy helps you buy more mutual fund units when market prices are low, and time allows your portfolio to recover from downturns.
The Retirement Withdrawal Challenge
Sequence of returns risk becomes most dangerous during the withdrawal phase, particularly in retirement. If your portfolio suffers market declines early in retirement while you continue making regular withdrawals, capital erosion accelerates rapidly.
Even if markets recover later, your portfolio may never fully recover because less capital remains invested during the recovery period. This risk can force retirees to lower their lifestyle expectations or face the possibility of running out of money sooner than planned.
"Sequence of returns risk tends to be underestimated by investors," said Vishal Dhawan, founder of Plan Ahead Wealth Advisors. "It can result in a retirement portfolio running out of money sooner, or the need to lower lifestyle in retirement, which can be very disruptive."
Practical Strategies to Manage Sequence Risk
Investors can take several practical steps to mitigate sequence of returns risk:
- Diversify across asset classes: Spread your investments across equity, debt, and gold to reduce sharp drawdowns during market volatility.
- Maintain asset allocation discipline: Ensure that your withdrawals or investments do not depend entirely on equity market performance.
- Use multi-asset portfolios: These can provide stability during equity downturns.
- Create a debt buffer: Near retirement, gradually reduce equity exposure and maintain cash or debt reserves to cover living expenses during market declines.
- Continue SIPs during accumulation: Systematic investment plans help mitigate risk by buying more units during market downturns.
The timing of returns, especially during the early years of investing or withdrawal, creates a lasting impact that simple averages fail to capture. By understanding and managing sequence of returns risk, investors can better protect their financial future and achieve more predictable retirement outcomes.
