Impact of Sequencing Risk

The timing of poor market returns, also known as sequencing risk, can have a significant impact on investment outcomes. This type of risk is specifically more challenging for retired individuals as they have minimal to low income to cope with the changes in the market dynamics. Sequencing risk is where the order and timing of investment returns are unfavourable, which results in less money for the retirement corpus.

To understand it in a better way, let us go through an illustration. Consider two scenarios.

Scenario I:

Here we assume that you had invested Rs 5 crore in S&P BSE Sensex at the start of April 1990 and remain invested till March 2020. You get the returns similar to what Sensex has grown. This is denoted by blue line in the graph.

Scenario II:

Here we would just inverse the returns starting from March 2020 to April 1990, keeping the investment amount the same. This is denoted by the red line in the graph.

Further we have also assumed that you withdraw Rs 2 lakhs every month in your retirement years for the next 30 years. This will help us to understand how sequencing risk can affect your financial plan.

As can be seen from the graph, when you start withdrawing in the bear phase of the market, your withdrawals will severely impact your retirement corpus considerably even though you will still be able to survive with this scenario. 

Impact of Inflation Rate

In the above case we have not considered any inflation while withdrawing from the retirement corpus. We have kept Rs 2 lakhs as constant. Nevertheless, it will be naive to assume that Rs 2 lakhs will have the same purchasing power for the next 30 years. Hence, we need to account for inflation-adjusted withdrawal that keeps your purchasing power intact.

Now that we have accounted for inflation, you can see the drastic difference between the two scenarios. In the first case, the terminal value at the end of 30 years is Rs 4.53 crore as against your original investment of Rs 5 crore. In the second case, you generated a negative compounded annual growth rate (CAGR) of 0.32 per cent. This is how sequencing risk affects your investments.

Now if we increase the rate of inflation by 1 per cent, we can see the intensity of the sequencing risk getting deeper. In such a case, if you are retired during the bear phase, there are high chances that you will outlive your retirement corpus and your survival would get more financially challenging. This is what the second scenario indicates.

Inflation at 7 per cent is what is assumed as a general rate by many financial planners. If we adjust the same rate of inflation for withdrawal, then you would be able to survive only for 22 out of 30 years. In the remaining eight years you would witness negative cash flow.

If we consider the worst-case scenario where inflation touches 8 per cent, the sequencing risk further damages your portfolio and obviously you will outlive your retirement corpus. This can be seen in the second scenario. In such a case, you would be able to financially survive only for 19 years. For the remaining 11 years you would face a cash flow shortfall.