Why order matters in returns

B. VENKATESH Sequence of returns will determine your portfolio wealth. A capital loss of 5 per cent will hurt. But the effect will depend on whether this loss precedes or follows a ! per cent "ain. Three factors determine whether you will achie#e your life "oals. $irst is your disciplined approach to sa#in"s. Second is your choice of in#estment products. And third is your portfolio%s return e&perience. 'n this article( we discuss how your portfolio%s returns e&perience in each period( called the sequence of returns ris) *S+,,-( can affect your life "oals and how you can moderate this ris). Understanding SORR Suppose( your initial in#estment capital was ,s 5 la)h and your contri.ution was ,s 5!(!!! e#ery month .etween /ecem.er 0! 0 and 0! 1. Based on the actual returns on the Nifty 'nde&( your portfolio would ha#e accumulated ,s (25(022 .y /ecem.er 0! 1. But what if the order of returns3e&perience were chan"ed4 Assumin" the same initial capital and monthly contri.ution( if the monthly returns on the Nifty 'nde& were re#ersed *if /ecem.er 0! 1 returns were actually e&perienced in /ecem.er 0! 0 and li)ewise for the rest of the months-( your portfolio would ha#e accumulated ,s (56(6 2. 7e also arran"ed the monthly inde& returns from the lowest to the hi"hest returns and #ice3 #ersa. 'f your portfolio suffered all ne"ati#e returns first and all positi#e returns later durin" this 13month period( your portfolio would ha#e accumulated ,s 0(58(659 .y /ecem.er 0! 1. But if you earned all positi#e returns first and ne"ati#e returns later( your portfolio would ha#e .een 5 per cent lower at ,s !(22(8!6. This e&ercise shows that your portfolio wealth depends on the order of your returns3e&perience. 'ma"ine the effect on your portfolio when your in#estment hori:on is 1! years; The ris) that you will fail to achie#e your life "oals .ecause the order of returns3e&perience could affect your portfolio wealth is called S+,,. <ou run this ris) whether you contri.ute capital or withdraw capital from your in#estment portfolio. S+,,( thus( affects .oth wor)in" professionals and retirees. Moderating SORR <our portfolio si:e will .e lar"e as you approach retirement. And that is when your portfolio is e#en more #ulnera.le to the sequence of returns3e&perience. <ou can moderate S+,, .y

reducin" your equity in#estments as you enter your wor)in"3life side of the retirement ris) :one => the ! years approachin" your retirement. Note that a typical portfolio will contain a.out 05 per cent equity in#estment at retirement. <ou can( therefore( only moderate and not eliminate S+,,. 7hat if you fail to accumulate the required wealth at retirement despite moderatin" S+,,4 Typically( you may ha#e to resort to one of the two choices? you can defer your retirement date if possi.le or reduce your post3retirement consumption. But you can also morph part of your retirement portfolio into your retirement income portfolio and retire without reducin" your li#in" e&penses *for more details( read @Brid"in" shortfall in retirement portfolioA that appeared in this column dated Septem.er 00( 0! 1-. But what if you are already retired4 <ou run hi"h S+,, especially durin" the ! years immediately after retirement = the retired3life side of the retirement ris) :one. <ou should )eep your equity in#estments to a minimum durin" this !3year period. <ou will .e e&posed to S+,, only if you withdraw cash from your equity portfolio. So( one way to reduce your S+,, is to ha#e sta.le cash3flow products( such as annuity *prefera.ly- or .an) fi&ed deposits to fund your monthly li#in" e&penses. Conclusion <ou will .e e&posed to S+,, whether you are a wor)in" professional or a retiree. +nly those contri.utin" lump3sum money and holdin" their portfolio throu"h the in#estment hori:on do not suffer from S+,,. Note that S+,, is not mar)et ris). Bar)et ris) is the ris) that your portfolio will decline with the mar)et. S+,, is the ris) that the order of returns may hurt your portfolio #alue = whether your portfolio e&periences( say( 5 per cent loss first and ! per cent "ain ne&t or the other way. 'n#estin" is( indeed( uncertain; *This article was pu.lished on Canuary ( 0! 5-

Feeling happy with index funds?

B. Ven)atesh <our happiness depends on what you compare with. Aimin" for moderate returns on your in#estments can reduce your re"ret and ma)e you happy.

Sometime .ac)( we discussed in another column *DKeep returns e&pectations moderate% in Knowled"e Ar.itra"e dated Au"ust !( 0! 1- that it is "ood to aim for mediocre returns. +ur o.Eecti#e was to help you moderate your re"ret. But will you .e happy earnin" mediocre returns4 To answer this question( consider lon"3distance air tra#el. Suppose you frequently fly .usiness class to the FS. 7hile .usiness class is "ood( you desire to tra#el first class. 7hat if your airline up"rades you to first class on one of your return3le"s from the FS4 <ou would( no dou.t enEoy the rich e&perience of first class tra#el. But your su.sequent tra#el to the FS would most li)ely .e misera.le; 7hy4 <ou will compare the .usiness class tra#el to your first class e&perience and feel unhappy a.out the facilities that the former does not offer. So( what should you do to enhance your .usiness class e&perience4 Ger#erse as it may seem( you should tra#el economy class at least once e#ery year; That way( you would .e a.le to appreciate your .usiness class e&perience; 'n other words( your e&perience is much .etter and feelin" of re"ret much less if you occasionally tra#el economy and frequently fly .usiness class than if you occasionally fly first class and frequently tra#el .usiness class; Now( consider your in#estments. 7hen you aim for mediocre returns( your o.Eecti#e would .e to .uy inde& funds. Comparative happiness <et( two factors could ma)e you happy with your inde& fund in#estments. +ne( the occasional losses on your equity portfolio would ma)e your more frequent a#era"e3returns e&perience appear .etter; And two( you will .e occasionally tempted to in#est in hi"h3ris) in#estments that @promiseA hi"h returns( e.".( farm land in#estments and quant3.ased tradin" strate"ies. And when such in#estments yield losses( your inde& fund returns appear .etter; 7e are not su""estin" that you should ne#er e&perience lu&ury ser#ices such as first class air tra#el. Neither are we encoura"in" you to suffer losses to appreciate mediocre returns on your in#estments. ,ather( what we are su""estin" is that a mediocre outcome will appear "ood when compared to a .ad outcome( whereas a "ood outcome will appear mediocre when compared to a .etter outcome. <our happiness will depend on your frame of comparison( not necessarily on the actual returns earned. 'n fact( e#idence su""ests that happiness does not typically increase with wealth after you pro#ide for your .asic needs.

This does not mean you should stop aspirin" for more wealth. But it may .e worthwhile to shift your frame of reference( especially if you fail to acquire more wealth. 'f nothin" else( it would reduce re"ret and ma)e you feel happy. *This article was pu.lished on Canuary ( 0! 5-