SIP in Equities – don’t forget this ignored component !!

SIP is the new “in” thing..

In recent times there have been several ads and articles focusing on the benefits of SIP (systematic investing plan) in equities (via equity mutual funds).

Systematic investment plan or SIP as it is commonly referred to, is a disciplined investing process where you keep allocating a predetermined amount every month irrespective of the market conditions.

The key advantage is the fact that you don’t need to time the market and it aligns with the income pattern (monthly salary) for most of us.

The basic idea behind SIP is that since we consistently invest over a period of time, we are able to average out both declines as well as upside movements (assuming markets continue to remain cyclical as they have been historically.

Now the overall intent behind an SIP is good – i.e to make investing in equities simple and to address the behavioral biases of investors.

However I believe there are few important caveats which are not being discussed and might lead to a sub optimal experience for investors. Let us see them in detail below:

But remember “Equity returns are non linear”..

The most important thing in my opinion for any investor while investing in equities is to understand the fact that

“Equity returns are non linear”

i.e the returns in equities are not equally spread across years and are extremely volatile. The returns fluctuate between high and low significantly and as seen below while the overall average returns are good, they hide the intermittent sharp declines and sharp up moves which occur in intermittent periods regularly.

Source:BSE

And there is the ignored 100% equity exposed portfolio which keeps growing with time..

An SIP addresses the volatility issue reasonably well during the initial years. But however what is being ignored is the fact that as the time period of an SIP increases you also end up with a reasonably sized corpus which remains 100% invested in equities and hence exposed to the volatility of equity markets.

Lets assume you had planned an SIP of Rs 10,000 in HDFC Top 200 (a popular equity mutual fund) every month for 15 years starting from 01-Jan-1998.  The value of SIP as on 01-Jan-2008  would have become Rs 94.5 lakh. But one year later, on 01-Jan-2009 the value of the SIP would have become 53.3 lakhs (remember the 2008 subprime crisis , the Sensex fell 52% while the fund fell 45%) . Basically in one year your corpus has come down by a whopping ~41 lakhs.

That’s a huge decline from an absolute perspective and behaviorally it becomes extremely difficult to remain in equities. (Now before you go blaming equities..Relax, the SIP value recovered to Rs 1.03 cr as on 01-Jan-2010 ).

The same SIP had it been started on 01-Jan-2005 you would have ended with Rs 7.4 lakhs in 01-01-2008 and a year later would have declined to Rs 5.0 lakhs as on 01-Jan-2009. Here the impact on corpus is not that high, with the decline being ~ 2.4 lakhs.

Do you see where we are getting at??

In the initial years the SIP corpus is small and while the volatility of equities continues to keep the corpus volatile, the impact on an absolute basis is to a great extent manageable provided you have a long investment time frame and reasonable confidence on the fund.

But as time progresses, the compounding effect comes into play and your corpus also becomes sizable. The sizable corpus is 100% invested in equities irrespective of the market conditions which implies a 2008 like crisis can have a significant impact on the overall portfolio and most importantly to your sleep 😦

As portfolio crosses the threshold, shift to an Asset Allocation Strategy

So the key is to decide a threshold corpus beyond which we will move the existing corpus into an asset allocation strategy (a mix of debt, equity and gold based on the time period left).

While a temporary loss (provided you don’t panic and sell) of 50 lakhs might be ok for someone, I might be able to withstand only say Rs 30 lakhs.

The ability to withstand a decline is different for different people..

So how do we decide the threshold level ??

As a thumb rule, equity investors must be prepared for a temporary decline of 50%  as evidenced for the Indian equity market history and as seen in other global markets. Now generally losses for human beings are not in % terms but in absolute value terms. So a 50% decline on Rs 10,000 is qualitatively significantly different from the same 50% decline on Rs 10 lakhs.

I personally would like to evaluate my investment corpus in terms of my annual income.

So let us assume someone earns Rs 5 lakhs per year. He has managed to save around Rs 30 lakhs. Now a 50% decline will imply a Rs 15 lakh fall. But a better way of appreciating the true impact is to view it as his 3 years of hard work vanishing on a computer screen in just 6 months !!

I would be ok to handle a temporary loss of up to 2.5 years of my annual income in promise of higher returns in the future. So that implies I am ok with a 100% equity exposure till my corpus reaches 5x my annual salary.

Now different people will have different tolerance levels.

You can decide on your tolerance levels based on years of your annual income which you don’t mind seeing a temporary loss.

Summing it up,

As a quick rule of thumb, you may keep approximately 5x your annual income as a threshold for your equity SIPs (or adjust it based on your risk taking ability).

The moment it crosses the threshold you will need to start actively managing the equity exposure i,e follow an asset allocation with debt, equity and gold (will write a separate post on how we can do that). So when you are running an SIP in equity mutual funds, make sure you set your threshold.