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The recent fall in the equity markets has seen some investors getting negative returns on the SIPs that have been initiated over the past one year or so. This raises the question as to whether SIP should be discontinued during bear phases of the markets.
Let us recapitulate what an SIP is and its benefits.
A systematic investment plan (SIP) is a disciplined way of investing in mutual fund schemes, in which an investor can make equal payments at regular intervals (normally monthly) over an extended period to accumulate wealth over the long run. It inculcates the habit/discipline of saving and building wealth for the future.
Benefits of an SIP
As a common investor doesn’t have enough time and resources, SIP proves to be viable option. Listed below are the key benefits of this instrument.
• Reduces risk because of rupee cost averaging
• Timing the market is not necessary
• Long-term financial goals can be aligned with SIP
• Disciplined approach towards investment helps in controlling emotions
SIPs make sense only if invested regularly for a long period of time. If you get into an SIP only for a short period, the returns generated are insignificant or volatile. As the investing period goes on increasing, the gap between amount invested and market value of the investment goes on widening substantially. Time works like a lever in the market: large amounts of return can be earned by investing comparatively smaller amounts of money, if invested consistently for a long period of time.
Another way of looking at benefits of long-term investing would be to calculate the amount of investment required to earn Rs 10 million (Rs one crore) if the SIP was started more than five years ago, more than ten years ago, and so on.
If you want to earn Rs 10 million (Rs one crore) in five years at 12% XIRR, you need to invest Rs 125,000 a month. You can earn the same Rs 10 million by investing just Rs 10,500 per month, if you stay invested for 20 years. Investors who signed up for SIPs across diversified-equity funds for one year bore losses (negative returns) in 22.5 per cent of the cases. But as they increased the period of the SIP, the incidence of losses fell dramatically.
SIPs that lasted two years delivered losses to investors in 16.2 per cent of the cases. Three-year SIPs ended with losses in 9.8 per cent of the cases. As per the analysis, a four-year SIP had a 5.9% probability of ending in losses. But had you wished, you could have reduced that chance of loss to almost zero -- a 10-year SIP yielded a negative return just in 0.3 per cent of the cases.
The philosophy behind starting a SIP with an equity scheme is to go on investing regardless of the market conditions. Investors should not stop it in downturns, but should keep the SIP running for a longer period. Otherwise, they will lose out on the chance to make money in the long term. Here’s why:
1. Rupee cost averaging: This is an approach or a benefit wherein the investor can buy more units when prices are low and less when prices are high. Ideally speaking, most investors want to buy stocks when the prices are low and sell them when prices are high. But timing the market is time-consuming and risky. Rupee cost averaging can help reduce the average cost per share over time (provided the investor does not stop SIPs in bear markets) and increase your profit when the cycle turns and markets start rising.
However, this mechanism doesn't guarantee a profit or eliminate risk, and it won't protect you from a loss if you sell shares at a market low. Before adopting this strategy, you should consider your ability to continue investing through periods of low price levels.
2. Power of compounding: Compounding means that the money you make off an investment can be reinvested to make even more money than your initial investment. The money you make goes back to work to make you even more money than before.
Let's say you've invested Rs 10, 000 and it makes 10 per cent interest a year. In the first year, you make Rs 1,000 in interest. But in the second year, you'll make Rs 1,100 (not only does your initial investment of Rs 10,000 earn interest but so does the additional Rs 1,000 you made in the first year). In the tenth year, you'll make Rs 2,358. And in the 30th year you'll make Rs 15,864. All of that comes without making another investment beyond your initial Rs 10,000. Hence the longer you stay invested, higher will be the benefit of compounding.
In conclusion, investors shouldn’t worry about stopping SIPs when the market is declining. In fact, that is the period when an investor can accumulate more units at a cheaper cost and then benefit from the eventual up move in the markets. SIPs are done by investors to meet long-term goals and should be done for at least 5-10 years. They should not be worried about near-term volatilities or small negative returns in the near-term. Corrections are the best time to accumulate maximum numbers of units for the future. In fact investors can use this opportunity to increase SIP amount by using a top-up facility provided by the fund house.
Deepak Jasani is head of retail research at HDFC Securities.