Why the order of market returns can make or break your portfolio
This critical factor often overlooked by investors can dramatically alter long-term wealth, even with consistent average returns.
MUMBAI : The order of investment returns can significantly affect the final portfolio outcome, even if the long-term average return remains the same—this is called sequence of returns risk. It is most relevant during periods when an investor is adding to or withdrawing from a portfolio, rather than simply holding a lump sum.
However, there are ways to mitigate this risk. A well-thought-out asset allocation can help cushion the impact of negative equity returns by allocating capital to assets with low correlation with equities.
In theory, two portfolios earning the same average return over a period should end with the same value. In reality, that is not always the case. When returns arrive in a different sequence—strong years first or weak years first—the end result can vary meaningfully.
This risk is particularly important in equity investing because stock market returns are uneven. Markets rarely move in straight lines—sharp drawdowns and strong rallies are part of the journey.
Take, for example, two investors who earn the same average annual return of 10% over four years.
• Investor A earns returns of +20%, +15%, –10%, –5%
• Investor B earns returns of –10%, –5%, +20%, +15%
If both invest a lump sum and make no additional investments or withdrawals, the final outcome may be similar. However, the outcome changes completely when investments are made over time.
If an investor is investing ₹1 lakh every year through a systematic investment plan (SIP). If the initial years deliver poor returns, the portfolio value remains depressed for longer. Subsequent positive returns then compound on a smaller base, meaning it takes significantly higher returns just to catch up.
In contrast, if strong returns come early, the portfolio grows faster, and future gains build on a much larger base.
However, the impact of sequence of returns risk is less critical during accumulation phases. This is because an SIP enables rupee-cost averaging, which helps you buy more mutual fund units when market prices are low, and time allows the portfolio to recover from downturns, which isn't possible once withdrawals start.
Sequence of returns risk is more critical during the withdrawal phase, such as retirement. If a portfolio suffers market declines early in retirement while regular withdrawals continue, capital erosion accelerates. Even if markets recover later, the portfolio may not recover fully because less capital remains invested.
So why must investors be watchful? Because the timing of returns—especially during the early years of investing or withdrawal—can have a lasting impact that averages fail to capture.
How can investors manage this risk?
Diversification across asset classes such as equity, debt, and gold helps reduce sharp drawdowns. Asset allocation discipline ensures that withdrawals or investments are not entirely dependent on equity markets.
“Sequence of returns risk tends to be underestimated by investors, and can result in a retirement portfolio running out of money sooner, or the need to lower lifestyle in retirement, which can be very disruptive. Using multi-asset portfolios and creating debt for the initial years to cover living expenses in case of an equity downturn can be a strategy to mitigate this risk," said Vishal Dhawan, founder of Plan Ahead Wealth Advisors.
An SIP helps mitigate the risk during accumulation by buying more units during market downturns.
Near retirement, gradually reducing equity exposure and maintaining a cash or debt buffer can protect against early drawdowns.
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