Some critics argue that systematic investment plans (SIPs) expose your investments to high risk when market valuations are rich. In this article, we discuss why SIP is optimal for most individuals despite its inherent risk.
Market timing
Goal-based portfolios typically have a long-term horizon. Continually timing the market for multiple goals may require lot of time and effort. Also, the more frequently you try to time the market for multiple investments, the more you are likely to risk making suboptimal decisions. Hence, the SIPs.
The tenure of an SIP on a passive equity fund must preferably match the time horizon for a life goal; the SIP for an active fund must be for 12 months at a time. The structure of an SIP is such that you will invest a fixed sum of money every month. This is behaviourally optimal because you are aware of the proportion of monthly savings that goes into your chosen equity fund. The automatic debit from your bank account means that you do not have to worry about forgetting to make the investment every month. But there is an issue.
Value averaging
Suppose you set up a monthly SIP for ₹20,000. You invest the same amount through the tenure of the SIP, whether the stock market has been continually moving up or down.
The argument that critics make is investing the same amount when the market is trending up exposes your investment to high risk. After all, if stocks are on a consistent uptrend, they are more likely to take a dive when the momentum slows down. This is a valid argument. An alternative investment process called value averaging addresses this issue. But the process requires your continual involvement, unlike an SIP.
Conclusion
A study on market timing suggests that returns will be significantly lower if you miss the ten best trading days in a year. Likewise, your returns will be significantly better if you are not in the market during the ten worst days.
The issue is that you will know the ten best and worst days only in hindsight. Even if you get it right one year, can you bank on your skill and luck to stop and restart SIPs through the time horizon for all your goals?
That is why continuing your SIPs is optimal despite the downside risk. That said, reducing your equity exposure during the last five years of the time horizon for your life goal is very important.
(The author offers training programmes for individuals to manage their personal investments)