Among the many methods available to safeguard ones investment from stock market volatility, the most popular is to invest a fixed amount at periodic interval irrespective of market conditions. This is of course known in India as systematic investment plan or SIP.
One could add an aspect of market timing by gauging returns with respect to a target portfolio with a pre-determined return. If after a specified period (usually a month as in SIP) the actual portfolio is less (more) than the target portfolio, the investor increases (decreases) the investment amount. Thus this is equivalent to investing more on market lows and less on market highs. The investor will have to fix a target return and nominal investment with which the target portfolio is calculated. A minimum investment (to be made when portfolio exceeds target) and a maximum investment (to be made when portfolio falls short) also need to specified. This approach is known as value averaging investment plan or VIP. You can read more about this here.
Many people consider VIP a superior approach to SIP because although VIP does not always provide higher returns, the total VIP investment is expected to be typically lower. The answer to which is better depends on market trends that dominate the investment period. More importantly the effectiveness of any investment must always be checked with respect to the target portfolio.
Recently I had analyzed a report by Fundsindia in which they have taken a few mutual funds and compared both investment strategies. I found that for 10 out the 16 studies reported both SIP and VIP modes outperformed the target portfolio and for 5 out 16 studies both unperformed. Thus it is a bit like ‘together we fall, together we conquer’.
We cannot jump to conclusions based on this result because: (1) 12 out of 16 studies reported were only for 3 year periods. (2) many of the funds are actively managed funds (as pointed out by Ramesh Mangal) (3) one should consider rolling averages over, say, a 10-year periods as Subra pointed out. To address the first two issues I have made a comparator with monthly Sensex returns (date source: Capitalmind). One can choose any investment time period between 1980 to 2012 and see how VIP and SIP strategies respond to different market conditions.
Ideally, if I choose a 10 year period then I must choose all 10-year periods between 1980-2012 (total of 24), average the performance and stare at the results before making conclusions. I will try and set this up in future. I think quite a bit interesting information can still be obtained by trying out a fixed investment period over different market conditions.
A look at the time evolution of Sensex suggests interesting periods to try out.
I: 1980-1991. A period of strong growth
II: 1991-2001. A disappointing period to say the least.
III: 2002-2007. A dream period (enough said!)
IV: 2009-2012. Recovery + consolidation (in the eyes of an optimist that is!)
You can of course play with any period of your choice. Here are some results for these periods. I have passed a verdict on each method. Hopefully it is easy enough to understand.
VIP results for period II (1991-2001) are bizarre! In this 11 year period the stock market gave negative returns. A person who had started a VIP in 1991 would have invested 195% more than someone following the SIP mode and would still have fallen short of his target by 80%. Quite easily the worst possible advertisement for VIP! When the markets do well (periods I and III) it does not matter which mode you choose you will reach your target (duh!) Period IV is too short to say anything concrete. One thing is for sure if next year 11 years turn out to be anything like period II, then investors in index funds are screwed! Actively managed funds can be expected to perform better. However they will have to do a lot better to enable investors achieve their goals. Perhaps intelligent stock picking is the only way in such market conditions.
Wait a minute! Haven’t we have heard that if one stays invested in the market for long periods there is virtually zero probability of loss. We have also seen in many places that ‘long periods’ means at least 15 years. So let us look at the results for every 15 year period from 1980 and 2012:
In 10 out of the 19 possible 15-year periods both VIP and SIP modes fell short of the target portfolio (53%) 🙁
In only 4/19 periods both VIP and SIP exceeded the target portfolio (21%)
In 4 out of the 5 remaining periods SIP scored over VIP!
Only once did VIP alone exceed the target portfolio.
“When saving for financial goals people must invest some amount each month. Trying to vary that can yield disastrous results. Simplest VIP is to do a regular SIP (for the goal) and try to contribute another 2-3k or so on days whenever markets fall nearly 2% (say like Apr 4, 2013). Never miss SIP no matter what.”
What is of more concern is a 53% failure of both modes in the periods studied. When the markets are heading nowhere (period II and now!), VIP can be disastrous idea. The problem is SIP doesn’t do its job either. I am quite uncomfortable about this. Of course one can take partial comfort in the fact that ‘target’ portfolio here represents ‘equity-target’ portfolio and not ‘goal-target’ portfolio. So a diversified portfolio which has significant non-equity components (debt, gold, real estate etc.) will not suffer as much. To me these results suggest the following:
- Invest substantially in equity only if your goal is at least 15 years away
- Even then the equity component should be limited to somewhere between 60-40% irrespective of age, risk-appetite.
- Do not expect 15% from equity long-term or very long term. My goal calculations are all based only on 10% returns from equity. Nothing is guaranteed and a fall is a fall. Just that I prefer a drop from the 1st floor rather than the 5th floor.
- Ensure you invest each month systematically irrespective of market conditions.
- When the going is good, book some profit. Either systematically (that is rebalance with specific equity component in mind) or randomly (book some profit!). Ensure the booked profit is immediately reinvested in a debt instrument with minimum tax out-go.
- Investing in equity is the best bet to beat inflation. Remember it just a bet not a guarantee.
What do you infer from the above? Do you agree with me? Try out the calculator for different periods of your choice. If you find something interesting please let me know.
(.xlsx file made with Excel 2010. Except CAGR cells works with Excel 2007)
(.xls file Except CAGR cells works with Excel 2002)