S.I.P, don’t guzzle investments

At a glance

  • An ability to time the market, or to be able to anticipate when to be fully invested and when to be out of the market would offer opportunities for huge gains in relatively short periods
  • For instance, over a 20 year period, just being able to avoid every trading day that saw a decline of over 5% would enable 8x the returns that staying fully invested in the NIFTY would bring
  • But past record of market forecasts made by even the largest investment banks and asset management companies suggests an accuracy not unlike that of astrology
  • In 2013, most of the major banks revised the projection of where the SENSEX would end the year when the market had declined until September. Instead, the index climbed through until the end of the year
  • The calm investor knows that accurately anticipating what the market will do in the short term is impossible and hence looks to mitigate this uncertainty by adopting the SIP method of investing rather than investing all her funds at one time

Market Timing = 20-20 foresight

What if you had a way of anticipating every decline in the market so that you could sell your holdings and re-enter the market at the lower level?

Chart shows how ₹100 invested in the NIFTY at the beginning of 1994 would do over 20 years in three scenarios; staying invested throughout, selling before days of declines > 7% and selling before days of declines of > 5%, in both cases re-entering the market on the day after the decline.

Incredibly, by just staying out of the market for those 31 days of trading when the market declined by more than 5%, you would end up with over 8 times the amount in early 2014 than if you stayed invested throughout the 20 year period!

So, becoming very rich in a small amount of time in the stock market is only  a market of being able to foresee the down days and staying out of market on those days!

Market forecasts and astrology

3 Dec 2012: “Sensex poised to take 21,000 in 2013: BNP Paribas” NDTV Profit

13 Sep 2013: “BNP cuts ’13 Sensex target to 17k, sees one more correction” Moneycontrol.com

BNP Paribas revised their initial estimate for 2013 downward by nearly 20%. It’s not difficult to see why. After hovering around the 20,000 mark for most of the year, the SENSEX went from 20,302 on 23rd July to 17,968 on 27th August, a 12% drop in just over a month.

They weren’t alone. Here are initial and revised forecasts for 2013 from the leading financial institutions.


Instead of declining from 18,000 in September, the SENSEX went in the opposite direction for most of the next three months to end 2013 at 21,170. Not only were some of the most erudite financial minds in the business off by a fair degree, their forecast error actually went up when made for a three month horizon.

In keeping with these forecasts, had you pulled out your money from the market, you would miss out on the 17% increase from Sep to Dec. Or worse, if you had short sold the Sensex (possible with an instrument called ‘Futures’ that involve taking position worth several times your money), you would have sustained losses large enough to wipe out most retail investors.

If the financial powerhouses armed with decades of cumulative capital markets know-how and sophisticated models of mind-boggling complexity have no way of telling where markets are headed, should the calm investor, even try the forecasting game? The answer is of course, a resounding “No!”

SIP don’t guzzle

SIP

Accepting our inability to foretell the direction of the markets is a truly liberating feeling. It enables us to then think about the best ways to contend with the volatility that you know is an integral part of the market.

Systematic Investing is one such approach. The reference to this as S.I.P. or Dollar Cost Averaging (DCA) in most finance-related literature makes it sound more complex than it is. Systematic investing is purely the approach of investing a pre-defined amount, in a given investment vehicle, at pre-defined intervals of time.

The key benefits of investing systematically:

  1. Takes the guesswork and drama out: Instead of agonizing over whether a current price level for the index or a stock is excessive and where it might go, an SIP sticks with a defined amount at regular intervals (e.g. the 5th working day of every month) making it almost as mundane as paying your phone bill every month
  2. Buys low: Or rather, buys “more” when low. Since the amount invested is fixed, it automatically buys more of a stock when it goes down and less when it goes up. This helps managing the average cost price in your favour
  3. Is sustainable and habit-forming: Since the amounts involved on a monthly basis are nominal, it is easier to stick to than if you decided to invest a sizable amount every 6 months or one year when other commitments and prevailing sentiment might sway you
  4. Is easy: Almost all online brokerage accounts allow you to set up such a plan to invest in Mutual Funds and even equities with a few clicks
  5. Makes you a more mindful investor: Deciding to invest into a stock or fund on a regular basis is a commitment which causes you to pay more attention to the underlying company or portfolio thus weeding out the speculative picks you otherwise might have flirted with

Finally, a comparison of how a lumpsum investing approach compares against a monthly investment plan.

Let’s say you have ₹120 to invest in the NIFTY in any given year.

Lumpsum approach: involves investing the entire amount (₹120) on the 1st trading day of the year

SIP approach: involves investing ₹10 on the 1st trading day of every month. (note that even the lumpsum approach here takes on SIP characteristics when viewed over the long term but it’s still useful to consider)

Chart shows the comparison of annual returns over a 20 year period

  • The lumpsum returns exceed returns from SIP in most of the UP years(when NIFTY ended the year higher than it began) but performs worse in the down years. The median lumpsum return is 8.9% compared to 5.8% for SIP investing, a significant but deceptive difference if considered standalone
  • On a cumulative basis, the difference between the two approaches narrows. Table shows the portfolio for both approaches at different timelines, considering both invested a total ₹120 every year starting 1994 for five, 10, 15 and 20 years

  •  The variability in returns is higher with lumpsum investing. Coefficient of variation (Standard deviation / Mean) for lumpsum is 31% compared to 20% for SIP investing. In plain speak, that means fewer sleepless nights for a systematic investor

Compounding might be the most powerful force in investing, but making regular defined investments is right up there in terms of developing good investing habits and accumulating long-term wealth

References (external links):

Why market forecasts are so bad (Wall Street Journal)

Sensex forecast: Right the first time, wrong the second (Hindu BusinessLine)

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