Sequence of returns for wealth creation, why is it necessary ?

Every investor who deploys money in the market aims for wealth creation.

Typically, most people who are invested in the markets know that volatility is the name of the game. Investors have been told to aim for a decent compounded annual growth rate when looking at returns. For example, most investors when told to aim for 15 percent CAGR, tend to imagine a 15 per cent yearly increase in their portfolio every year. Actual returns, however, are almost never linear. Even though 15 per cent is the average, it does not mean that an investor will grow money at 15 percent every year. In fact, one of the most successful investors of all time, Howard Marks once quoted, “Never forget the 6 feet tall man who drowned crossing the river that was 5 feet deep on average.” He was clearly indicating that the depth of the river could range between 2 feet and 10 feet. Markets behave in a similar fashion. This is illustrated in the following table.

It is crucial to understand that markets do not move in straight lines—neither up, nor down. 2017 saw a large amount of liquidity that fuelled a one-way upward rally in the Indian mid-caps and small-caps. The opposite was true in 2018. Statistically, the chances of having a bad year after having a good year are high. This is known as mean reversion. So, the question is, does the sequence of returns matter if we end up with the same average CAGR? The answer to that question is a resounding ‘Yes!’

reverse returns vs sensex returns

The above graph clearly illustrates that 20,000 invested in the Sensex every month for 20 years would have yielded a real value of 2.11 crore, whereas if the returns were reversed, (that is, if the actual returns earned in the 20th year i.e 5.9 per cent were assumed to be earned in 1st year, actual returns earned in the 19th year i.e 27.9 per cent were assumed to be earned in 2nd year and so on) it would have yielded an ending portfolio value of 2.55 crore despite both actual returns and reversed returns earning the same average returns. The sequence of returns makes a massive difference to the final portfolio value. Thus, the strong returns earned in the early part of one’s career on a low capital base could end up being lower in terms of absolute return, when compared to a modest return in the latter half of one’s career when the capital base is significantly larger. Thus, a naïve extrapolation of using a CAGR over a long period of time to arrive at an ending portfolio value in hindsight is misleading.

The sequence of returns of an investor in the markets is almost impossible to control. Certain investors are blessed with lower returns in their accumulation phase, but strong returns when they have more money, while others are cursed with a bear market near retirement. This is known as the ‘sequence of returns’ risk.

We use the present day valuations to take guesses at what sort of gains the next several years may fetch, but the future is not guaranteed to look like the past and historical valuation metrics may become obsolete. This can be illustrated by the example of several ‘value-oriented’ American hedge funds which essentially contributed to their own downfall by short-selling Amazon and Netflix while accumulating JC Penny and Blockbuster over the last few decades.

The use of market valuations as an indicator can sometimes help investors estimate the possibility of a weak or strong market in the years to follow and rebalance portfolio allocations accordingly. This is by no means a perfect strategy, but it works effectively from time to time. For example, using a template for buying and selling stocks based on the Nifty PE ratio is a strategy some renowned investors adopt for making timely investment decisions.

Luck plays a large role in investment success. Its role is more significant than most investors realise. Each investor has only one life-cycle during which this plays out. Although it is very difficult to control the sequence of returns one earns over the investment horizon, there are some methods in which this risk can be mitigated.

These are as follows:
Be conservative

The most practical method to contain a sequence of return risk and give yourself a margin of safety is to have a slightly conservative return expectations, inflation projections as also saving and spending conservatively. A high savings rate means a smaller amount to replace when the portfolio is spent down eventually. High inflation expectations allow room for error in one’s personal inflation rate. Not overspending when market returns are high can help avoid having to cut back when returns are low. This is better than having higher return expectations and saving less, only to end up with a negative surprise.


The best part about simulations is that they force investors to be disciplined, but the downside is that they take away flexibility. Having flexibility in terms of saving rates, spending rates, the timing of cash flows and how investors behave in bull and bear markets can have a massive impact on the portfolio. These levers can always be adjusted on the basis of how the real world differs from one’s original projections. A strict savings rate, withdrawal rate, and asset allocation might look great on a spreadsheet, but these may need to be adjusted depending on how things play out.

Don’t be a forced seller

It can be extremely painful to be on the wrong side of the sequence of return risk. However, being a forced seller of stocks when they are down further compounds the problem, making it a double whammy. This can be avoided through methods like portfolio design, diversification and intelligent deployment of cash flows. Building up reserves in good times in order to survive the inevitable bad times can cushion the blow.

Manage volatility

Seasoned investors know that volatility is not the same as a risk in long term investing. However, volatility can be a drag on final results, if not managed appropriately. Reducing portfolio volatility in at least a part of the portfolio might be a wise move to be able to survive any major disruptions in the markets, the economy or your personal life. This also includes the volatility of human emotions when markets are scaling new peaks or crashing like a house of cards.

Understanding oneself

Risk management of investments depends on where one is in their own investment life-cycle. People at the beginning of their careers are going to have a completely different risk profile and time horizon than those who are retired and need to live off their savings. Withdrawing money from investments is completely different from building a portfolio through periodic savings. Risk matters when one is young, but not much. Risk really matters when human capital or the present value of future labour income is low or zero and one is planning to dip into one’s investment earnings for the remainder of one’s life.

The sequence of returns risk is present in international markets just as much as in the Indian markets. The actual S&P 500 returns showed a strong performance for a period of 10 years from 1987-1996, returning a total of 310 percent. The 10 years following that have been decent, but nowhere nearly as strong with a return of 95 percent. If we consider the exact same returns, but at different points of time, they throw up different results. This can be seen in the below illustration:

Thus, if one is a young investor who can continue investing for several years to come, a falling market proves to be an attractive opportunity to participate in the growth of the economy from a low base. We know that mean reversion is inevitable and markets will rebound. Investing, by definition, is for optimists. Investors should understand that when they invest in stocks, a lot depends on when they need the money. Ideally, equities should be treated as a long term asset class. In the stock market, investors should deploy capital which is not needed for the next 5 years. Nobody wants to end up with a bear market when there is a need for money.

returns life cycle

For retirees, the sequence of returns risk applies even during the period of retirement. In the early years of retirement, the portfolio value remains fairly large when compared to withdrawals. The opposite is true in the next half of an investor’s retirement. This is because a large part of the portfolio is spent down late into retirement, leaving the portfolio size to be relatively small. Thus, retirees would naturally hope for higher returns early into their retirement in order to have more retirement income. Every individual has unique goals. However, it is generally observed that an individual who is retired would prioritize sustaining retirement income for remaining life over aiming for strong capital appreciation to leave a legacy behind. As such, the possibility of experiencing poor returns in early retirement is a scary thought.

In conclusion, young investors should aim for strong late returns when their investment corpus is substantial, over strong early returns when an investor is still in the accumulation phase. Retirees will prefer strong early returns in the early phase of retirement when the portfolio size would be considerably large. The investment corpus will generally be spent down by late retirement and portfolio size will be small. It is important to realize the importance of sequence of returns on one’s portfolio. It is important to mitigate this risk to the extent possible. Investors should remember the importance of mean reversion while setting return expectations. All investment decisions should be taken after careful consideration of one’s own investment life-cycle.

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