PERSONAL FINANCE: THE BIG MARKET RISK INVESTORS IGNORE NEAR THEIR RETIREMENT
When the equity market dipped recently, there were many comments on social media on how this would affect investors who have just retired. While this is applicable to any and every market dip, I thought I would explain why this is a concern.
There is a risk that comes when your retirement commences during a market decline. The drop in market value coupled with withdrawals from your corpus detrimentally attacks the longevity of a portfolio. When you start making portfolio withdrawals, the value of your portfolio reflects both market performance and cash outflows, which can be a double whammy during extended market downturns.
Let me explain.
Let’s say your corpus is Rs 10,000, and you withdraw Rs 1,000 per annum.
If you earn 10 per cent (first year), 10 per cent (second year), and -10 per cent (third year), you'd end up with Rs 8,000 by the end of the third year.
If you earn -10 per cent (first year), 10 per cent (second year), and 10 per cent (third year), you’d end up with Rs 7,580 by the end of the third year.
All I did was reverse the order of the negative return from the first year to the third year. And you can see the impact. The negative return at the beginning of the period (when more assets are in the account) carries more weight in the overall results. The portfolio doesn’t benefit as much in rupee terms from the two years of positive returns because there are fewer rupees remaining.
Different sequencing of returns shows different results. Hence, this is called Sequence-of-returns risk, or Sequence Risk.
Now if I increased the withdrawal amount by a bit after a year or two, due to inflation, the impact would be greater.
Why does this happen?
The timing of withdrawals, paired with stock market losses, results in a lower corpus for future growth when the market eventually rebounds.
You pull money out when the value of the portfolio is falling means that there’s less money left to benefit from the next rally; less money to compound.
While it is very difficult to overcome those losses in early years, just imagine the reverse. The early years of positive returns would turn it in your favour.
Just imagine a 15 percent annual gains feeding your portfolio; you will start your retirement with a bang, and your portfolio will grow even while sustaining an ambitious withdrawal rate.
US-based Retire One recently put out an excellent graphical visual on Sequence Risk. They plotted returns from the Dow Jones Industrial Average with two portfolios. Both portfolios ran for 15 years, both portfolios had an average CAGR of 4 percent, and both portfolios started with US$1,00,000.
The difference was that Portfolio A had a bear market over the last 5 years while Portfolio B had a bear market in the first 5 years. Portfolio A landed up with US$1,05,944 while Portfolio B ended up with US$35,889. Despite the identical annual return, Portfolio A has $70,055 more than Portfolio B simply because it enjoyed a bull run at the start.
How can you combat Sequence Risk?
You must take Sequence Risk seriously because withdrawing from a portfolio that’s simultaneously declining reduces the probability that the assets will last through the whole of someone’s retirement time horizon.
One way out is to plan your retirement when a bull run commences. However, I have no suggestions on how to time this or, the nuances of such an approach.
A more practical way is to maintain your asset allocation. It is shocking how individuals just do not take this seriously and keep tanking up on stocks during a rally. If you have enjoyed gains from equity over decades, start to lower the equity allocation just before you retire. Begin to de-risk your portfolio in favour of other assets.
Christine Benz, Director of Personal Finance and Retirement Planning, Morningstar, always recommended the Bucket approach to retirement portfolio construction.
- Bucket I: Highly liquid to meet near-term living expenses for one year or more.
- Bucket II: Five or more years’ worth of living expenses, with a goal of income production and stability.
- Bucket III: Equity assets for long-term growth and inflation protection.
By following this strategy, investors can guard against the risk of being forced to withdraw their equity assets during a market downturn. This also leaves the remaining portfolio better positioned to rebound when the market eventually improves.
Sequence Risk is one of the least-talked about dangers of investing. Talk to your financial adviser to get more clarity, if need be. But don’t ignore it.
Larissa Fernand writes on personal finance and investing. She focuses on understanding the mindset of investors and their relationship with money. Views are personal and do not represent the stand of this publication.
2025-04-21T03:16:03Z