A friend of mine called me the other day. He was curious to know if SIPs are a foolproof way to invest in equities? Is there any way they won't work well for me?
I went on to explain.
You often hear that SIPs are the best route to gain exposure to equities. And i believ the same. Mainly because they eliminate one of your (an investor's) biggest enemy, your emotions. Emotions that usually misguide you into making all the wrong decisions.
Let's understand this better.
Thre is a good chance you (Investors) might start their SIPs at the worse possible time when the market has peaked. As you are not able to cut through the noise around you. Everyone you know has made their fair share of profits and are bragging about it. So you decide to join them at the worse possible time. Hoping the markets will continue to rally and so will your SIPs investments. Unfortunately, that's usually not the case as there is a good chance the markets will fall.
Similarly, you (investors) might stop investing in bad times out of fear, losing out on what is perhaps a great opportunity. This is where an SIP comes in handy. It doesn't allow you to react to your emotions or the market noise. As the name suggests, SIPs are a systematic plan. A plan where your money is automatically deducted from your account towards your choice of mutual fund, regardless of the market situation. Eliminating one of you're the biggest fear - mistiming the markets.
But there are few instances where investing via the SIP route can be disadvantageous.
Investing via SIPs only for a short period of time
If you are investing for a short period of time, say 3-6 months, SIPs might not help.
The stock markets, much like business cycles, have a cycle of their own, filled with troughs and peaks. The key to generating strong returns is to let your investments ride through these cycles. So you must invest throughout the market cycle which can last anywhere between 3 to 5 years. Hence, its always advisable to only allocate long-term money towards equities. The money you won't be needing over the next 3-5 years.
Investing in SIPs thinking they can save your investments from a falling market
SIPs cannot save your investments from falling markets. Their value will fall and rise with the markets. But, yes SIPs do eliminate the need for you to time the markets. They lower the risk of mistiming the markets and solve the dilemma of when to invest. Whether the markets rise or fall, you stay invested, eventually making money.
Better understood with an example:
Let’s assume you think the markets are overpriced i.e., you expect them to fall from 36,000 today to 33,000.
SIP or lumpsum you will lose money if you were to invest your savings today in the stock markets. The method of your choice doesn’t matter. The money will eventually be allocated to the stock market, which will fall along with the value of your investment.
Alternatively, you expect the markets to rise from 36,000 now to 38,000. You will be better off not taking the SIP route and investing all your savings at once (lumpsum). This way you will get that extra bang for your buck. But if you put it in the SIP your cost of investments will also rise with the markets.
So, if you happen to start your SIP at market peaks there is a good chance you will lose money initially. But, mostly, by the end of the first year, you will break-even and start to turn a profit. Bringing us back to the original point, you have to ride out the market cycle and allow your investments to grow.
Investing in a poorly performing fund
Some investors tend to forget that SIPs are a method of investing in mutual funds. They are not an investment instrument themselves like fixed deposits, stocks, mutual funds, bonds etc. So, your SIPs performance is directly linked to your mutual fund's performance. If the mutual fund is no good, the SIP method of investing alone cannot shield your money.
It happens often that after choosing the wrong mutual fund, investors blame the SIP method of investing. Not realising realise it was their choice of fund all along.
So they try to make it better by tweaking their SIPs. They stretch their SIP tenure hoping it will help generate returns, making things worse. As sticking to SIPs in poorly performing fund increases your opportunity costs. You would be better off cutting your losses and moving on to a better performing fund.
To ensure you have made the right choice, review your fund's performance regularly. Make the relevant comparison with its peers and benchmark.
Keep in mind that SIPs are not a magic wand or an investment trick that can turn your bad investments into good. Therefore, the key to taking full advantage of a SIP method is by investing over the longer term and by choosing a good fund that reflects all your financial goals.