Equity mutual funds have seen heavy inflows in the last couple of years from retail investors. Not surprisingly, a large chunk of retail money has come through the systematic investment plan (SIP) route. So, what exactly is a SIP?
As the name suggests, a SIP involves regularly investing a fixed sum of money each month on a specified date into an equity mutual fund. SIPs can also be weekly, daily or quarterly, but monthly SIPs are the most popular. So instead of investing a lump-sum of Rs.120,000/- into an equity mutual fund, you create an SIP account with an equity mutual fund to invest Rs.10,000 each month for a period of 12 months. The empirical evidence has been that SIPs have been a low-risk method of outperforming the market.
How and why does a SIP work in practice?
As discussed earlier, the SIP tends to work across all kinds of markets. By default, stock markets tend to be volatile and it is almost impossible to predict the tops and bottoms in the market. However, equities have consistently generated annualized returns of 16-18% over the longer term. This may not be necessarily applicable over a 2-3 years period, but if you look at a period of beyond 5 years, this tends to be true. The reason a SIP works in practice is because timing the market does not add value in the longer run, at least when it comes to mutual funds. Here is why
Case 1: Let us take the case of two investors A & B who start out with an SIP at the same time around mid-2011. Investor A fixed 10th of each month as the SIP date and invested Rs.10,000/- religiously on that date. He did not worry about whether the Sensex was quoting at a P/E of 25 or at a P/E of 15. He also did not bother about the likely implications of global geopolitics or about what the Fed and RBI would do in their monetary policy. Over the next 5 years, Investor A infused Rs.600,000 into his equity MF SIP and earned annualized returns of 17% over the 5 year period
Case 2: Investor B was not only a smart trader but also a little more ambitious and believed in the power of market timing. He therefore decided to take a view on the markets and increased his monthly SIP amount each time the market crashed and reduced the SIP when markets had gone up. He would track analyst comments, media reports and global macro trends to decide whether he must invest more or less in a month. At the end of 5 years, Investor B had also invested Rs.600,000 into his equity MF SIP and had earned annualized returns of 17.2% over the 5 year period
The moral of the above two cases is that if after all this effort and taking on the timing risk, the investor is just going to earn 0.2% extra, then it is surely not worth it for retail investors. We also need to remember that market timing, like the way Investor B did, is prone to risk and could make the portfolio returns volatile. When both the above factors are considered, a regular and disciplined SIP seems to be the answer. Investor B was simply not earning attractive additional returns to justify the higher risk and effort.
Is this right time to start an equity mutual fund SIP?
As on April 19th 2017, the Nifty is quoting at Price Earnings (P/E) ratio of 23.10 and the Nifty Dividend yield is 1.26. Both of these are closer to the higher end of the P/E range that the Nifty has quoted at. While one can debate over whether this is the right time to get into lump-sum investments, you need not overly worry about starting off on your SIP for 2 reasons. Firstly, over a longer period of time, the SIP can be indifferent of the levels of entry as long as you can maintain discipline. Secondly, the earlier you start the SIP the better. The longer time period you have, the more you will invest. The more you invest, the more will be your returns and more will be the returns earned by your returns. That is the power of compounding and nowhere does it manifest better than in case of an SIP. Consider the live illustration below (Source: Value Research):
Had you started with an SIP of Rs.5,000/- per month in HDFC Equity Fund (Growth)on May 01st 1997, then you would have invested Rs.12 lakhs till date. However, your investment value would have grown to a whopping Rs.1.89 crore implying an annualized compounded return of 23.43%. During this 20 year period, the equity markets have been through the 1998 slowdown, the Kargil war of 1999, the tech boom and bust of 2000, 9/11 attacks of 2001, the bull run of 2003 and the Lehman crash of 2008. The markets have also seen wars in Iraq, Afghanistan, Syria and Crimea as well as Europe going to the brink of an economic crisis. Despite all these vagaries, the equity SIP has returned 23.43% annualized. That is what the power of compounding over a longer time frame is all about.
That is also the reason why you need not really worry about when you start your equity SIP as long as you can sustain in a disciplined manner. When it comes to equity SIPs, it is time and not timing that matters!
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