How SIPs really work

Anupam Gupta |  Apr 14, 2016 09:40 AM IST

There are only so many ways to multiply money in the stock market. You start with a certain amount, keep investing, and then hope that the market carries you forward for a long period of time. The mutual fund industry calls this method ‘systematic investing’. There’s a moral angle too. Unlike a gambler you don’t wager all your money on one horse, on one race and hope and pray that it wins. No, you keep investing steadily and keep hoping that it grows. You show faith, show commitment, show loyalty. You’re in for the long term. You get rewarded with ‘compounding effect’ which is like some magic wand that keeps multiplying your money many times over. And there is all sorts of data to show that over the long-term, stock markets provide fantastic returns and hence, the only way to long-term wealth is steady, committed investing via the popularly known method – ‘systematic investment plan’ or SIP. 

Nothing wrong with this. But there a few things investors should know before jumping in:

1. 15% returns isn’t guaranteed: Often enough, you will hear people saying that over the long-term, the Sensex provides 15% returns. Indeed, the 25year return (or 1990 to 2015) for the Sensex is 14%. But this is a ‘CAGR’ number – it smoothens out year-to-year returns. And as we all know, the Sensex is anything but smooth. When you break down the 25year period, you will notice that a majority of those returns came from 2002 to 2007 when the Sensex went from 3,377 to 20,287 – nearly seven times. That lumpy, chunky return more than compensates for dismal periods like 2007 to 2013 when the Sensex was flat. A better way out? Ask for rolling returns instead of ‘CAGR’ returns. And the data on that is far more realistic: currently, 10year rolling returns are at 8%, 15year rolling returns at 13% and 20year rolling returns at 11%. None of these are anywhere near the promised 15%. 

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2. Even a recurring deposit compounds your money: The compounding effect is cool but even putting money in your savings account regularly will compound your money at 4% per year – risk free. Banks also offer recurring deposits at higher interest rates. Sure, tax and inflation will eat away most of the gains, but understand this – the compounding effect isn’t a magic trick. When markets are down – as they have been for the past six years – your corpus will suffer. Even a lump-sum investment in well-chosen different stocks will enjoy the compounding effect over a long period of time. Compounding effect isn’t an exclusive benefit for SIPs. Holding on to any investment for a long period of time will gain from the compounding effect – provided the investments are growing in the first place. 

3. Timing matters: It’s funny that since 1980, in no single calendar year did the Sensex give that mythical 15% return. Taken in aggregate, however, from 1980 to 2016, the CAGR is 16%. This is what long-periods do for you. They smoothen out year on year volatility. That’s what an SIP does – it simply ensures that the chances of you losing money reduce over the longer term. Unfortunately, timing still plays a big part. A SIP started in 2000 (at the peak of the Sensex) would keep seeing its value deteriorate till – finally – the market picks up and the SIP starts to pay back. Obviously, the reverse applies in bear markets. For flat markets – such as the one you’re currently witnessing – your corpus would most likely be equal to amount invested since the market is literally not giving you any return. 

To sum it up- SIPs aren’t magic wands. Investors should understand their limitations before expecting them to perform miracles. Equities aren’t a guaranteed return product, and SIPs only dull the effect of everyday volatility in equities by showing you the big picture in the end.

Anupam Gupta is a Chartered Accountant and has worked in equity research since 2000, first as an analyst and now as a consultant. He contributes to the Business Standard platform, Punditry, through his blog, Beyond Markets on markets & the economic horizons. 
He tweets as @b50
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