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Bad sequence of return

Much is said and written about the risk of inflation and how equity allocation in the portfolio can help protect and increase purchasing power of money.  More and more investors are waking up to the necessity of having equity in their portfolios. Equity Mutual funds are increasingly becoming preferred choice of investment for retail investors. Recent run in the equity market has further augmented conviction of investors as well as advisers in equity.

While volatility of return in equity is often talked about, there is one inherent risk to equity investing, which is neglected, rarely talked about and much less understood. This risk is bad sequence of return risk. It is the risk of receiving lower or negative return early in a period when withdrawals are made from an individual’s portfolio. Before moving to the sequence of return, let us first talk a little about prevalent practice of financial advice in India and one serious flaw in it.

Financial planners use linear average return assumptions for equity and inflation while designing financial plans. These assumptions allow them to project cash flows into the future neatly and precisely. Certain rules of thumb for asset allocation are followed. Asset allocation is considered by many as the holy grail of investing. It is believed that, once asset allocation for each financial goal is done, everything will be smooth and fine. Cash flows are projected as much as 30 years into the future. Financial plan looks well organised and adviser appears to be in total control.

Unfortunately, this approach of projecting linear investment returns into the future, works fine only on spreadsheets. In real world, financial plans prepared using linear average investment returns, can fall flat on face, since investments don’t grow in straight line at the assumed average rate in the real world. Let us try to understand this with a hypothetical example.

A 65-year-old retired man with corpus of ₹80L, wants to do his retirement planning. This man has monthly expense of 50K, which will increase with inflation every year. He wants to plan for 20 years in retirement.

The man goes to a Mutual Fund seller adviser for his retirement planning. This adviser thinks that balanced fund is one solution, that fits all retirement problems. He strongly believes that balanced funds can generate 12% annual return, even with conservative estimate. This adviser has also back tested the strategy of a 100 percent balanced fund portfolio for retirement distribution phase, with last 20 years of Indian market history, and found that the strategy works fine.

When old man approaches this adviser for his retirement planning, adviser puts numbers into his retirement calculator for a 100 percent balanced fund portfolio to calculate the corpus required. For 12% portfolio return and 7% inflation, calculator throws 83L as the required corpus to finance old man’s retirement for 20 years. Since calculations are done with conservative return assumptions, adviser thinks that 80L corpus old man has, can easily finance his 20 years in retirement. He confidently advises old man to park all his corpus into balanced funds and rest assured.

Old man is a wise man. He never takes any decision before seeking second opinion. So, he goes to one more financial adviser for advice. This adviser believes in asset allocation and re-balancing. He takes conservative assumptions (according to him) of 15% average return from equity, 7% post tax return from debt and 7% inflation, to do his calculations. He finds that conservative equity allocation won’t be enough to finance old man’s retirement. Therefore, he incrementally increases equity allocation to see what equity allocation can finance 20 years of old man’s expenses in retirement.  He finds that old man needs to allocate at least 60% of his corpus to equity to be able to finance 20 years in retirement.

Old man finds second adviser more reasonable and his advice safer compared to the first adviser and goes ahead with it. As advised, he parks 60% of his corpus (48L) into large cap mutual funds, and 40% (32L) in ultra-short-term debt funds. Old man is new to mutual fund investing and has his share of concerns about the safety of his capital in mutual funds. But adviser assures him by showing past return history of mutual funds in India that looks attractive owing to the recent bull run in equity market.

Everything goes smooth initially after old man makes his investments. Bull market takes equity indices further higher. Old man sees his investments grow faster than he ever expected. In 3 months, his 48L initial investment in equity MF becomes 52L. He now starts thinking that he should have better listened to the first adviser and parked all his corpus into balanced funds, since debt portion of his portfolio is not giving him any return. He also starts thinking of a foreign vacation now which he never did before.

Unfortunately the merry time only lasts for 3 months and global financial crisis hits markets like tsunami. Markets all over the world start falling. Panic sets in. Business news channels which were discussing all-time highs of stock market few days back, start adding fuel to the panic now. Old man goes to meet his adviser in fear. Adviser being a competent man, calms him down with his charm, confidence, poise and charisma. Old man listens to the adviser and keeps his investments untouched.

In the meanwhile, market keep going further down and within a year it comes tumbling down 50% from its peak. Even adviser begins doubting his faith in the equity and starts losing his long-held poise. His argument for staying invested in equity no longer carries same weight as it used to carry at the start of the market crash. Old man finally gives in after months of sleepless nights and emotional suffering. The 48L he had invested in the equity mutual funds is worth less than 25L now and he has 28L left in debt mutual funds since he withdrew from debt for his household expenses. He redeems all his investments both from equity as well as debt mutual funds.

From 80L at the beginning of the year he is now left with 53L, which cannot even support his 9 years in retirement with 6L annual expense, even if we don’t consider medical emergency expense he might face in the future. His fate would have been even worse had he listened to the first adviser. He is scared for life now. Even if equity markets recover and regain their lost glory, it is of no use to him since he will never again invest in equity.

Many cases like this must have happened in 2008 financial crisis in India and elsewhere. Accumulation portfolios are as much vulnerable to such rare events as distribution portfolios. Indian indices had corrected more than 50% in 2008. Investors lost $11.2 trillion from the U.S. stock market peak on October 9, 2007, to its trough on March 9, 2009 (India’s GDP is around $2.2 trillion). In 17 months, 60 percent of the world stock market wealth was destroyed.

Events like 2008 can kill portfolios constructed on the blind faith in average equity market return without taking into consideration the havoc bad sequence of return might cause. Many advisers do not give enough thought to the risk of retiring at the start of a bearish cycle which can cut short life of a retirement portfolio significantly. A bearish market cycle in accumulation portfolio nearing retirement, can push retirement further back. Market recovery has always been V shaped for Indian markets in the past and therefore many people argue that if investors don’t panic and stay invested, they can come out unscathed. But not panicking and staying invested in such situations is thousand times easier said than done especially for retail investors. Back-testing of investment strategies never use investor psychology as an input though psychology is an inseparable part of investing.

One important thing we need to understand is that just because Indian markets always had V shaped recovery in the past doesn’t mean that they will behave the same in future. Markets may not recover for long time after the crash. Equity market history in India is not long enough to draw any meaningful conclusions from it. Nassim Taleb explains this point better in his book Fooled by Randomness.
“The problem is that we read too much into shallow recent history with statements like “this has never happened before”, but not from history in general (things that never happened before in one area tend eventually to happen). In other words, history teaches us that things that never happened before do happen. It can teach us a lot outside of narrowly defined time series; the broader the look better the lesson. In other words, history teaches us to avoid the brand of naïve empiricism that consists of learning from casual historical facts.”

The biggest problem with advice like putting 100% of retirement corpus in balanced funds (where reverse rupee cost averaging works since more units are redeemed when market is down) or increasing equity allocation when conservative allocation cannot finance retirement (instead of asking investor to reduce his expenses) is that it doesn’t take unlucky outcomes and bad sequence of return into consideration. It leaves portfolios too much at the mercy of luck.  Although aggressive investment strategies and advisers who suggest them look smart in bull markets, success of these strategies depend more on luck than good counsel of the adviser. Luck plays bigger role in the success of aggressive buy and hold strategies than what advisers like to think.

The Luck factor in the success of a portfolio can only be reduced by following time tested practicalities of investing like not allocating any money to equity that may be required in 5 years, not allocating more than 60% to equity for any goal however long it may be, reducing equity allocation as retirement nears and bucket strategy for retirement distribution portfolios etc. While designing investor portfolios, advisers must think about the unlucky outcomes and try to construct portfolios that can overcome and withstand adverse conditions.

You don’t design bridges for average wind-speed and average traffic but for the worst conditions they might face. Financial Planning and investment advice is no different.

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