Strong Early Returns Vs Strong Late Returns

You already know that the markets don’t go up or down in straight lines. What this means is that if an investor gets an average return of 12% in 10 years, it doesn’t mean that he will get:

12%, 12%, 12%, 12%, 12%, 12%, 12%, 12%, 12%, 12%

It instead means that he will get something like this:

-5%, 22%, 4%, 13%, -17%, 57%, 10%, 19%, -12%, 29%

Or let’s put it this way:

Related to the actual sequence of return an investor gets in real life, I came across an interesting post that talks about how the end-portfolio size differs depending on whether the investor gets strong early returns vs strong late returns.

What is the difference you may ask…

This simply means that in one case, you get good returns in early years while in other, you get good returns in later years.

Does it matter?

Yes indeed… as you will see soon in the remainder of this post.

Let’s consider a simple example.

Suppose you are 30-year old planning to save for retirement at 60.

You have decided to invest Rs 20,000 per month or let’s say Rs 2.4 lakh every year for the next 30 years.

Now consider 2 different cases:

• Good Later Years – You earn 7% every year in the first 15 years and 14% every year during the next 15 years, on your investments.
• Good Early Years – You earn 14% every year in the first 15 years and 7% every year during the next 15 years, on your investments.

What will be the value of your portfolio after 30 years in either case?

• Rs 5.81 crore after 30 years (for sequence 7% followed by 14%)
• Rs 3.95 crore after 30 years (for sequence 14% followed by 7%)

That’s a large difference of about Rs 1.86 crore!

And that too for the same ‘average return’ during the 30 year period. Isn’t it?

Many of you may have guessed the reason.

It is because of the Sequence of Returns you get. That is, the order of annual returns that your portfolio is subjected to.

In the first case (where portfolio grows to a larger Rs 5.81 crore), you get strong late returns – due to which, a bigger corpus earns better returns (14%) in the later years. Whereas in the second case (where portfolio grows to a comparatively smaller Rs 3.95 crore), you get strong early returns – due to which, a smaller corpus earns better returns (14%) early on while the bigger corpus earns lower returns (7%) in later years.

And how do these two cases compare with the actual average return (10.5%)?

Here is how different the 3 scenarios end up looking, even though all have the same exact average returns:

And this is exactly what I wanted to highlight.

The sequence of returns that investor gets has a big impact on the final overall portfolio size.

You may be hoping to get a portfolio size based on your average return assumption. But the actual size may vary even though average returns are same, due to a different sequence of returns your portfolio undergoes. Averages and Actual differ (River Depth example).

And let’s take this a step further.

Let’s see how the actual investment in Sensex in the last 20 years fared when compared to the reverse sequence of returns.

In this scenario analysis, Rs 2.4 lakh (or Rs 20,000 per month) is invested in Sensex every year during the last 20 years. The sequence of returns that are given in the second column in the image below are the actual Sensex returns in the last 20 years. The value of portfolio changes as depicted by the green line in graph below. Also, a portfolio that runs on the basis of the reverse Sensex returns (the returns have been reversed in the third column) is shown as the blue line in the graph. 

As you can see, depending on the different sequence of returns considered (one real other reversed), the portfolio value varies every year and also, the final values are different.

So the sequence of returns does matter a lot.

All said and done, can anything be done for this?

To be honest, it’s difficult.

You don’t get to decide what sequence of market returns you get in future.

I repeat.

You don’t get to decide what sequence of market returns you get in future.

This simply but unfortunately means that we have no control over the sequence of returns in the markets.

It is possible that some of you may get better markets early in your investing career and worse ones later. Or if powers above favour you, then you may have not-so-great market returns during initial years but super returns in later ones. This is the very reason why young investors should pray for bad markets in initial years. It may be painful and may not be for everyone, but it’s a wonderful thing for real long-term investors.

But even though we cannot control the sequence of returns, we can manage the risk to some extent.

At times, using market valuations as an indicator can help you estimate the possibility of a weak or a strong market in the coming years and rebalance your portfolio accordingly. By doing this, only a part of the portfolio may be exposed to market returns when required tactically.

This is not exactly a perfect strategy but works often as is proven by this detailed analysis of Market Valuations Vs Future Returns.

So to more practically manage the Sequence of Return Risk, you should be slightly conservative in your return expectations. It’s better to have lower return expectations and save more than having higher return expectations and saving less but getting shocked later on when it is already late to do anything.