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Sunday, February 23, 2020

Trading with SIP in a Fickle Market

by Editor (editor), , April 25, 2018

Let’s understand this better with an example:

The equity market is characteristically volatile relative to other investment options. But there are times when this volatility intensifies, and regular traders in the market deem it volatile even by its own standards. This can make many uncomfortable. But there a considerable number of people who remain unaffected by this, largely due to the market’s most popular innovation - the Systematic Investment Plan, or SIP. While a SIP remains an evergreen option for investing in mutual funds, it becomes even more lucrative in a fickle market. How exactly, you ask? Let’s dive in:

Why SIP?

A SIP is an ideal way to generate long-term returns and avoid spending too much time and energy in ‘timing’ the market. Thanks to the concept of rupee cost averaging (while negating the need to make large investments at once), a SIP allows you to generate higher returns on your investments by reducing your costs. Let’s understand this better with an example:


Month

Amount Invested

Falling NAV

Units Purchased

Total Units Purchased

Average Cost

Month 1

10,000

15.032

665.247

665.247

Month 2

10,000

14.845

673.627

1,338.874

Month 3

10,000

14.121

708.165

2,047.039

14.655

Month 4

10,000

13.923

718.236

2,765.275

Month 5

10,000

14.181

705.168

3,470.443

Month 6

10,000

14.013

713.623

4,184.066

14.340

Total

60,000

4184.066

During market conditions such as the one above, the NAV of a mutual fund can fluctuate significantly, rising and declining at fairly frequent intervals. This can make timing entry and exit points very difficult and stress-inducing. However, if you were to invest via a SIP regularly, you’re able to lower your average cost. This translates into higher returns once the market has stabilized and begun its run upwards.

Take a closer look at the table above. By the end of the 3rd month, your average cost is lowered to 14.665, which is 2.57% lower than if you’d invested a lump sum amount of Rs.30,000 in the first month itself (at a NAV of 15.032). As we enter the following months, your average cost further reduces.

What’s interesting to note is that if you were to redeem all your units at the end of 6 months, your net profile/loss would be near-zero - you’d receive Rs.59,999.95 (4184.066 x 14.013). This can be entirely avoided if you continue with the SIP and wait for the market to stabilize and rise, in which case you get the opportunity to redeem at significantly higher gains. And think of the losses you’d run into if you’d invested Rs.60,000 in the first month itself! You’d be down by Rs.4,068 (60,000/15.023*14.013).

This isn’t a hypothetical scenario. Rather, this sort of show plays out regularly in the markets. Take the example of the recession of 2008, when the markets were in freefall, punctuated only by slight rises every now and then. A SIP in such times would continue to lower your cost, and put you in a position to generate higher returns once markets returned to normalcy. A lump sum investment, on the other hand, would:

  • Leave you with little funds to make further investments in case of continued dips, and
  • Delay your breakeven point and eventual gains since your cost would remain high.

The Difference between Direct and Regular Mutual Fund with a SIP

A SIPs impact is further magnified when it is done on a direct mutual fund, as opposed to a regular mutual fund. The difference between direct and regular mutual fund is quite simply the additional returns that a direct mutual fund gives it to its investors, by virtue of it having lower expense ratios (or annual fees). This savings in cost is then passed on to the investors. Over time, an additional return can grow to significant amounts, thanks to the power of compounding. Let’s do the math:

Let’s say you invest Rs.10,000 each, every year into a direct mutual fund and a regular mutual fund. The direct mutual fund’s Net Asset Value (NAV) is 100, while that of the regular mutual fund is 90.

You will then receive 100 units of the direct mutual fund and 111.11 units of the regular mutual fund. Assuming that the direct mutual fund delivers returns of 20.75% every year and the regular mutual fund delivers returns of 20% every year.

After the first year, the NAV would be as follows:

  • Direct mutual fund: 120.75
  • Regular mutual fund: 108

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At the start of the second year, you will receive 82.81 units of the direct mutual fund and 92.59 units of the regular mutual fund post your SIP.

After the second year, the NAV would be as follows:

  • Direct mutual fund: 145.80
  • Regular mutual fund: 129.6

At the start of the third year, you will receive 68.58 units of the direct mutual fund and 77.16 units of the regular mutual fund post your SIP.

After the third year, the NAV would be as follows:

  • Direct mutual fund: 176.06
  • Regular mutual fund: 155.52

Here is what your portfolio would look like after 3 years:


Direct Mutual Fund

Regular Mutual Fund

Total Amount Invested

Rs.30,000

Rs.30,000

Total Units Purchased

251.39

280.86

NAV after 3 years

176.06

155.52

Total value after 3 years

Rs.44,259

Rs.43,679

The difference between direct mutual fund and regular mutual fund is perfectly illustrated in the above table. You earn Rs.580 (or 1.327%) more over the same investment period if you start a SIP in a direct mutual fund versus if you start a SIP in a regular mutual fund. This difference can continue to escalate - both in terms of absolute value and percentage - if we’re dealing with bigger investment options and longer time periods.

A SIP helps investors avoid buying high and selling low. It’s clearly the more prudent way to achieve your financial goals. Not only is a SIP the optimal investment route in a fickle market, it also highlights the difference in returns between direct and regular mutual funds.



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