Introduction
A slowdown can be a very depressing situation in the market. The prices of stocks fall and returns from investments also go down. If you are an investor who has invested in a lump sum scheme, you may be looking at a way to exit the scheme and encash it to prevent further losses. If you have invested only in shares and the company is not doing well you may face losses. But what about SIPs? Are they a less risky proposition during a slowdown?
What is an SIP
An SIP is like a recurring deposit that you make into a mutual fund account of the same amount in monthly instalments. The returns are invested back in the scheme, and they give compounded returns. SIPs are usually preferred by those having lesser cash at their disposal for investment or those who are just starting out to invest in mutual funds. A slowdown may impact their earnings, and the fall in the returns of a fund may raise the question as to whether they should continue investing the same amount every month in a mutual fund.
Common sense knowledge states that an investor must enter the market when it is low. But the question we are tackling is what if the market goes down after we have entered it through an SIP. Is it still a prudent decision to continue. Actually, it is. SIPs work under the principle of rupee-cost averaging, which spreads the risk across the period of investment. Now what does this mean? Basically, when you invest through an SIP, what happens is that each monthly instalment is separately invested in different units of the funds. Thus, you tend to get more units for the same investment when the market is down and fewer units for the same investment when the market goes higher. This ensures that the cost of the units is averaged out as you have purchased units in all phases of the market. This way your cost of investment is lower as compared to buying mutual funds in bulk or going for quick turnaround schemes.
How does rupee-cost averaging work?
Let us take an illustration to explain this. For example, A has an SIP of ₹1,000 rupee every month.
The net asset value of the fund in the first month is ₹100, so A gets 10 units.
In the second month the NAV increases to 200, A gets 5 units.
The third month it falls back to 100, and A gets 10 units.
The fourth month, it falls to 50, and A gets 20 units.
If we calculate the average cost of units for these 4 months, it will be ₹4000, which is the total amount of investment, by the total number of units bought during this period, that is 45. The average cost per unit will be ₹88.89. So you can see the cost per unit is neither close to the lowest point, nor close to the highest point. Instead, it is spread out evenly.
Had A invested ₹4,000 as a bulk during the second month, his cost per unit would have been ₹200 and he would have got only 20 units. Had he invested ₹4,000 in the fourth month, his cost per unit would have been 50 and he would have got 80 units. These bulk investments would have saddled him with either too many or too little units, which would have impacted his returns. Also, he would have had to keep a close eye on the market fluctuations to know when to enter and exit. Instead, by investing in an SIP, A has been able to average out his investment risk and thereby get an edge when it comes to his returns.
Therefore, SIPs are safe when there is a downturn or when markets are volatile as they give steady returns over a longer period of time.