SIP smartly | Moneylife
Jay Shah
SIPs help you deal with market volatility. But blindly SIPping will land you trouble. Here is how to SIP smartly. This is the first such report on SIPs. Researched and written by Debashis Basu & Jason Monteiro
Most investors lose money in the stock market because they invest in wrong stocks at the wrong time. One of the ways to get around the first issue (wrong stocks) is to invest in good quality mutual fund schemes —assuming they would choose the right stocks for you. The issue of wrong timing is supposed to be addressed by averaging your purchases, also known as ‘Systematic Investment Plan’ (SIP), under which investors should invest a fixed sum at a regular frequency—usually every month. SIP works on the strategy of rupee cost-averaging where more units are purchased when prices are low and fewer units are purchased when prices are high. The cost per unit, over time, will eventually average out. This reduces the risk of investing a large amount in a single investment at the wrong time and at a high price.
SIP investing is ideal for investors who do not have a big lump-sum at the start, but can invest small amounts regularly. SIP, being a formula of investing gradually and regularly, also helps you to avoid the dilemma of making a sizeable investment at a single time and run the risk of seeing your wealth decline sharply.
All mutual funds encourage you to invest through SIPs. They promote it strongly, running campaigns for distributors to meet new SIP targets. It is beneficial for both of them. They get regular inflows on which they can charge fees (funds) and commissions (distributors). Most mutual fund schemes give the investor the option of monthly or quarterly investment. Financial planners and advisors advocate SIP probably because it has a veneer of method. If something goes wrong, you can also blame a widely-accepted method. As John Maynard Keynes is reported to have said: “It is better to fail conventionally than to succeed unconventionally.”
But beware; there are periods when SIP works and when it doesn’t, though we have not heard of fund companies or distributors tell you about when SIPs fail and why. SIP will work well over an investment period only if the two below-mentioned conditions are satisfied:
• Many of the purchases are made at a declining phase of the market;
• The market eventually turns up.
In this situation, every new purchase is made at a lower cost than the previous one, for several periods. Therefore, when the markets go up again, your average price would be lower than that of the initial purchase price. Thus, the investor would have made sufficient returns. Here is a chart to illustrate how SIP worked between 2000 and 2008. This is the best-case scenario for SIP, but not a typical one. In at least three cases where it will not work well:
• If the market is mainly down, not up. In this case, all your accumulated units are marked to a low final value;
• If the market goes sideways mainly. In this case, the average purchase price would closer to the final price. The returns will not be poor but not that great;
• If the market is headed down from a peak formed by huge overvaluation. The average purchase price, in this case, goes up compared to the final value as the purchases are made at the market peak.
If SIP doesn’t work on many occasions, what are these occasions and can we spot them? Yes, by some rigorous back-testing. We have done a lot of work on SIP, only the core of which we are putting out here.
Kicking the Tyres
We tested the SIP strategy on the Sensex, over the period from January 1991 to May 2012. We compared the returns of a lump-sum investment made at the start of the period and a systematic investment of an equivalent amount made in the same period. The results: Both SIP and lump-sum performed equally over the one-year, three-year, five-year and seven-year periods. It might stun mutual fund companies and their distributors who blindly herd investors into a SIP regime, that in the three-year, five-year and seven-year periods, the probability of SIP beating lump-sum investment, taking any start point between starting from January 1991, would have been as good as tossing a coin! If this does not rattle all financial planners and advisors who blindly borrow ideas from the West and implement them here, we don’t know what will.
By increasing the investment term to 10 years, SIP did comparatively better, outperforming lump-sum investment on a greater number of occasions. We did a 20-year analysis as well, but due to the extremely low prices in 1991, lump-sum investing did better.
When Did SIP Fall Behind?
Lump-sum did better in periods when SIP was started just before a market peak. One such period was from November 2003 to November 2008. This five-year period provided no opportunity for an investor to buy lower than the previous purchase price, except towards the end—after the market crashed. Despite the crash, a lump-sum investment would have given a CAGR of 12.50% whereas a SIP in this period would have given an internal rate of return (IRR) of just 0.48%. However, it is unlikely that we may see such a period again for a long time.
SIP can mean capital loss!
There are no guarantees for market-linked products. You could lose money in stocks, bonds and equity schemes, depending on when you buy and sell. What are the chances of losing capital through your SIPs? Look at the five-year periods between January 1991 and May 2012. There were 197 such five-year periods when you could have started your SIPs.
It might shock you to know that you would have lost money on 41 occasions. That is, there is a nearly 20% chance of losing money for running a SIP over five years. In seven-year periods, you would have met with almost the same fate. For the 10-year SIPs, the percentage chance of loss would get reduced to 15% but it still is there.
When Did SIP Work?
We now come to the crucial issue of when SIP actually did work. While history may not repeat exactly the same way in future, it does give us little more confidence to follow a strategy whose success in the past was not random. So let’s look at when SIP worked. The five-year period from February 2000 to February 2005 was the best period for SIP, compared to a lump-sum investment —even though at the starting period, the market was at its peak. The Sensex dipped from over 6,000 to below 2,600 before moving back up again. A lump-sum investment at the start of the period would have earned you 4.27% whereas a SIP would have fetched you as much as 21.47% (IRR). This was a period, which boosted the returns for the seven-year and 10-year SIPs which started around the same time.
The volatile period from January 1994 to December 2003 was an ideal period as well, for SIPs. This period gave several opportunities to buy low. In this 10-year period, a lump-sum investment would have earned 5.73% whereas a SIP would have done better with an IRR of 9.27%. A five-year SIP between January 1995 and December 2000 would have returned 17.24% compared to a lump-sum, which would have gained just 9.75% in the same period.
What are the lessons? The value of your SIP—like your lump-sum investment—depends when you start and end with respect to the market. You cannot predict where the market will end up three, seven or 10 years from now, but what is within your control is starting the SIP when times are more favourable. Start your SIP when the market valuation is low, or at least not high —as is probably the case now. Does this sound like you have to time the market? True. But isn’t SIP touted to be a reason for avoiding market-timing, which is inherent in lump-sum investment? Yes, it is. But, as we have demonstrated, you cannot get great results by ignoring market valuation. If fund companies and distributors push you into SIPs, irrespective of the market valuation, it means that they either haven’t tested this or are not telling you the truth.
Using SIP for Lump-sum Investment-
SIP is useful for those who have a regular stream of earnings, saving money and have a long investment horizon. What about those who already have substantial fixed-income investments and want to move a lot of it systematically into risk assets like equity mutual funds? Surely, you would not want to put the entire sum into equity funds at one go. Should you distribute it equally over all the periods? Investing through a SIP seems a safer option. But, there is a way to do it. You may keep your money in the bank and start a SIP to the mutual fund you have chosen. However, you would earn a meagre 4% from your savings account.
Better still, put money in a liquid fund scheme and then create a systematic transfer plan by which your investment from your liquid fund would be systematically transferred to your equity fund. As liquid fund schemes invest in money market instruments, you could earn an average return of 6% per annum.
For the past one-year period ended 31 May 2012, these schemes returned an average of 9.30%; 10.57% was the highest return and 7.29% the lowest. The best advantage that liquid fund schemes have is, well, liquidity. There is no entry-load or exit-load and thereby you can put in cash and withdraw at anytime. If you had done a systematic transfer plan (STP) for the same periods we mentioned earlier, you would never have lost money in the seven-year and 10-year periods. In the five-year periods, your chance of loss would come down to 4%, compared to 15%—had you made a lump-sum investment. Only on eight occasions you would have lost money. These were periods when a lot of purchases were made closer to the market peak, raising the average purchase price. Even then the maximum loss was just 1.56% which (for the period September 1996 to August 2001). A lump-sum investment for the period would have gone down by 2.79%. The maximum loss registered through lump-sum investing was 7% whereas an STP would have ran a loss of just 0.40%. Therefore, you can improve your chances of coming out better than lump-sum investing using an STP method.
We tested this method with an equity scheme and liquid scheme of the same fund house for the period December 2006 to December 2011 when the index returned 2.31% and a SIP on the index returned 0.29%. Had you invested in the equity scheme through a normal SIP, you would have earned an annualised return of 3.49%. However, had you put your entire money in the liquid scheme and systematically transferred it to the equity fund, your annualised return would be as much as 7.12%.
Finally, for the Smarter Saver
You would like to start saving for a long-term goal, such as your retirement, for which you would like to set aside a small amount from your income each month. Investing in equities is the key for long-term wealth generation. But setting up a SIP is not enough. Consider this: your income is not going to remain the same over the coming years; it is going to grow. So, your SIP investments should not be of a fixed amount. It should grow. This would ensure that you save more and more each year. This is called growth SIP.
The chart Improved SIP is a comparison of a normal SIP and a SIP with growth option. In the growth option, we have assumed a 10% rise in the money allocated for SIP per annum. Apart from accumulating more wealth, your returns would have been 5% better in the 'Growth SIP' option for the period from December 2006 to December 2011.
Conclusion
SIP makes investors save regularly and takes away the emotion and uncertainty of investing under volatile market conditions and the temptation to time the market. But if you have a blind belief about SIPs, you will be sorely disappointed. Trying to time the market takes a lot of in-depth research, but you should also know that SIP often does not improve expected returns. The best action would be to avoid trying to time the market and to aim to make regular savings, but without committing themselves to an unnecessarily rigid SIP strategy. Remember, SIP is a risk management tool with a limited function. The function is to prevent you from investing lump-sum at market peaks and encouraging you to spread out the risk over time.
Some Facts & Myths about SIPs
Myth: SIPs prevent losses when done over long periods.
Best Regards,
Jay Shah, FRM
Expect the unexpected!!!