How to systematically reduce the risk associated with a SIP

I am not a mutual fund salesmen. Therefore I have no problem in pointing out that a mutual fund SIP, in particular in an equity mutual fund  does not reduce the risk associated with the equity market in any way. All a SIP does is buy units at different market levels. Some high, some low. No matter when you buy, the corpus accumulated is exposed to the full volatility of the market. If it crashes, then when you purchases those units (even if you did not do a SIP) will not matter.

Which is why managing the risk associated with the corpus is more important than when you buy next. A point made in the first part of this topic - Do not enter equity markets if you do not know how to get out!

If you have not read that, I request you to please head there and then come back here.

Now assuming we are all on the same page, a quick recap. Yesterday, I had considered two (of the several) de-risking strategies one can think of.

  1. Returns do not matter: Something which I strongly advocate
  2. Changing Asset Allocation in Stages. This post presents the back-testing data associated with this method.

The study

I have considered a 15-year goal in which one invests systematically in an equity fund and a fixed income fund. For the equity fund, I have considered the S&P 500 index from Jan 1st, 1900 (Excel would not allow dates before that although data is available!). Our indices are a new-born in comparison.

For the fixed income, I could not get my hands on a US bond fund. So I have assumed a constant 3% annual return. This is not true in reality, but the idea here is to assume that the volatility of the fixed income instrument is zero when compared with the equity instrument - just about reasonable.

The S&P data was previously used in the  Dollar Cost Averaging aka SIP analysis of S & P 500 and BSE Sensex. I strongly urge you to look at these results to understand how risky a SIP can be without dynamic asset allocation.

I have considered every possible 15 year period from 1900 to may 2015: 1205 data points in all.

For each period, compute the total corpus obtained

  • For a fixed asset allocation of 60% equity and 40% fixed income throughout the investment tenure
  • For a variable asset allocation (de-risk) as shown below. Two variants were considered in this case
    • Rebalancing every year
    • Rebalancing every three years.

sip-rebalancing-5

 

This is a random choice with no hindsight bias associated. You could change this in any number of ways.

Rebalancing each year

sip-rebalancing-1

Here the constant 60:40 equity:fixed-income allocation (corpus plain) is compared with variable asset allocation with annual rebalancing. Each line has 1205 data points and each data point represents a  15-year sip. The horizontal axis is the date of stating the SIP.

Backtesting with the various sequence of returns tells you how risky the past has been and that the future could be at least that risky.

Interpreting this  can be tricky if you focus on the three big peaks.  Please look at how much the corpus-plain swings, up to down. If the asset allocation is fixed throughout the investment tenure, then that is the risk we bear. We could end up with a much higher corpus than we desire or a much lower corpus - the danger we wish to avoid.

The dynamic asset allocation model in which equity exposure decreases as we approach the end of the 15 year period (the blue line) has a much smaller swing range. For about 40% of the 1205 periods, the blue line has a higher corpus than the red line.

No, that is not small! It is not possible to reduce risk without reducing returns. By adopting a de-risking strategy, we reduce the possibility of loss - getting a much lower corpus than desired or in this case, being found among that 40%. Of course, the 40% is not a probability and that the future could turn out worse than the past.

Diversification, asset allocation, rebalancing and de-risk are risk reduction methods. They may also reduce returns. Read more: Diversification will lower investment returns!

Rebalancing every three years

If you think rebalancing every year is a pain from the point of view of tax and exit loads, you do so less frequently or even consider threshold rebalancing - do nothing unless your asset allocation deviates by 5% or 10%. Here I consider triennial rebalancing - once every 3 years.

sip-rebalancing-3

Now the blue line follows the red line more closely.

To put this in perspective, the returns with the always-100% equity folio (blue line) is compared with the always-60% equity folio (red line) and variable asset allocation with triennial rebalancing (green line)

sip-rebalancing-4

Here again, the reduction in risk and reduction is obvious.

Two things are to be borne in mind:

  1. No one (practically) is going to make this kind of comparison with our portfolios. We just adopt a strategy, adjust to it (instead of adjusting it!) and make do.
  2. It is easier said that done to claim that one can do better than this by alternative methods. In real-time, all rules can fly out the window! Which is why I prefer keeping the goal in mind without worrying about the return.

We have to choose a method and see how it goes. The only message from this post is that a method is necessary and that

  1. Systematic investments do not reduce risk, but
  2. it is possible to systematically reduce the risk associated with a systematic investment!

Feel to let me know if you require clarifications on this study. Personally, I prefer a combination of both de-risking ideas considered yesterday.

Planning this beforehand

Please use the Financial Goal Planner with Flexible Asset Allocation for planning asset allocation changes before hand. This will ensure the right amount is invested.This calculator is for multiple portfolios. You can be rich too with goal-based investing, our new book has a calculator for a single portfolio.

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Related Reading

Simple Steps to De-risk Your Investment Portfolio

A Mutual Fund SIP or STP do not minimise investment risk!

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Install Freefincal Retirement Planner App! (Google Play Store)

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3 thoughts on “How to systematically reduce the risk associated with a SIP

  1. Mohit Singhania

    Wow Wow wow I have been reading your blog for the past x months and have found useful posts...no offense, but none were as mind boggling as this...
    I admit that after reading it 3 times, i am still digesting some of the minor genius nuggets but by and large i must say this is by far the best post i have read
    Please include more data backed albeit a little complex posts in the future as well.

    Thanks again.
    Now if only there was a way to get this in Hindi, i can share this with my dad. I was just trying to say something like this (without any data backing up my claims) to him a month back.

    Reply

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