Is SIP overrated? I tweeted last morning, only to realize how much investors are in love with SIP.
These were some interesting replies on the thread..
“It is impossible to not get good returns if SIP is done for 5 to 7 years”
“There are 2 types of SIPs, one is an investment strategy and other is marketing strategy”
“SIP is a tool that allows you to invest in good times as well as bad times, it handles volatility for you”
“SIP are the way to create wealth, but only if they are continued for long term”
“Best part of SIP is value averaging”
“No better way to get into equity funds for a layman”
All these statements are correct, but what made me worried was the fact that no one mentioned that SIPs do carry risks. In any asset class or financial product there comes a phase where it starts looking so attractive that people forget the risks which it carries. What happens after that is no ones guess!
No doubt that SIPs are an efficient way to invest in equities, but they don’t eliminate the risks that its underlying asset carries. All risks associated with Equity investing exist even when you are investing through SIPs. However, there are ways in which you can mitigate these risks by seeking professional advice.
So what are the key risks in SIPs?
SIP is just a way to invest in equity funds and they don’t necessarily mitigate risks that are inherent to equities, such as volatility in returns, point to point risks, drawdowns and limitations of value averaging.
Let’s see an example:
Below table shows year on year growth of Rs. 10,000 monthly SIP started in a small cap fund on 1st Jan 2006 (inception of this fund was in 2005). I have chosen smallcap fund to show the extremes and many investors love them today. The value of this SIP is as on Aug 2018 and later I have shown what returns one will make if market were to fall by 10%, 20%, 30% and 40% today.
Since Jan 2006 to..
No of Installments
|Invested Amount||Investment Value||Returns (XIRR%)|
|13||Aug-18||If Market Falls by…||10%||40,27,179||14.3|
|13||Aug-18||If Market Falls by…||20%||35,79,715||12.7|
|13||Aug-18||If Market Falls by…||30%||31,32,250||10.7|
If Market Falls by
(Market fall is an assumption and may or may not happen in one straight month but over a period of 12 months and returns may vary)
Now Let me explain each risk using the above example:
Year on year returns are not linear but volatile.
If you notice the returns on investment (XIRR) in first 5 years ranges between 73% to -17%
From year 5th to 10th returns range between 19.3% to 2.3%
…and from 11th year to 13th year returns range between 20.7% to 15.3%.
Assuming, market falls anywhere between 10% to 40% in the last year i.e 2018 (which is possible in any market cycle and especially in smallcaps) the returns can fall as low as to 8.5%, even when you invested consistently for last 13 years through SIP. This shows that SIPs cannot control volatility of the underlying asset class and only and only MARKET decides how much you earn from your SIP.
Point to point risk:
Goal based SIP is the most common pitch for many to start a SIP. Imagine your goal was set in year 6th, 8th or 13th when markets fell, your returns would have been very low and probably you might have missed achieving your goals.
This analysis is best explained through rolling SIP returns, but just because I don’t want to complicate things for many readers who may not understand the concept of rolling returns I will stick to simplicity.
If I were to put rolling return analysis in simple terms, a 10 year SIP returns in Nifty 50 index have given returns anywhere between less than 6% to more than 15%. This takes into account all possible 10 year investment periods since 1995. This shows that, when you redeem your investments, is the deciding factor of your returns, more than the time you have spent doing SIPs. If markets are good in that particular year then your returns are healthy, if you are caught in a bear market towards end of your SIP tenure then returns may be poor, no matter how many years you have been investing. Of course longer the period of SIP this risk is reduced, but it does not get eliminated.
The biggest fear in equity investing is drawdown. SIP doesn’t save you from drawdowns when markets falls. In the above example corpus was down due to market fall in 2008, 2011 and 2018. It is worth noticing that in 13th year of the SIP i.e in 2018 the SIP corpus has fallen from Rs. 55 lakhs (in Dec 2017) to Rs. 43 lakhs (in Aug 2018) led by sharp fall in smallcaps.
Limitations to value averaging:
Value averaging is the most powerful feature of SIP. However, this has its limitations too. Longer the SIP, lower is the power of value averaging. This is essentially due to the growth in corpus size and the amount of monthly SIP remaining same.
If you start a SIP of Rs. 10,000 per month in 10th year the corpus stands at Rs. 34 lakhs (as shown in the example) And if market falls, how much value averaging can be achieved with Rs. 10,000 monthly installment on a corpus of Rs. 34 lakhs? Even if we consider full one year contribution of Rs. 1.2 lakhs it is still less to get full benefit of the market fall and reduce overall cost of investments of a corpus as big as Rs. 34 lakhs. In such a scenario one needs to invest much higher amount to do effective value averaging, regular monthly SIP installment shall not help.
Hence, value averaging works well only in the initial period of SIPs when the incremental monthly SIP contribution as a proportion to the accumulated corpus is higher. Later, the power of value averaging weakens to aid the large corpus and fails to achieve effective value averaging.
Poor Fund Selection:
Last but not the least, how sure can we be that the fund we have selected for a 20 year SIP will consistently perform well and outperform benchmark or its peers. This is a huge risk. Many investors haven’t made money despite doing long term SIPs, this is essentially due to poor fund selection. This in my view is one of the biggest risk.
So next time you do a SIP remember these risks!
Having highlighted these risks doesn’t mean one shouldn’t venture into investing through SIPs. They are surely the best possible way to create wealth from equity mutual funds. But one should know these risks and try to manage and mitigate them by seeking professional advice is the only purpose behind highlighting these risks.
How do you mitigate and manage these risks… wait for next blog in this series where I will try to cover steps one can take to mitigate these risks in SIP.
Till then Happy SIPing!
Secret: Your XIRR returns on your SIP or lumpsum investment remains almost same in the long term. The fund performance and market contributes majority of the returns, not the way you invest in them.
Lump sum vs SIP: 11 years
Month after month returns (CAGR for a lump sum and XIRR for SIP) are shown for investments in Quantum Long Term Equity Fund from April 3rd 2006. Source: Freefincal.com – read full article here https://freefincal.com/lump-sum-vs-sip-investing/
The above data shows that “over the long term” the risk of a lump sum and that of a SIP is not very different. Thanks to Freefincal.com for this wonderful analysis.