Modified SIP

There is a class of stock market participants that believes in Systematic Investing Process (SIP). Of course, financial advisors, mutual fund managers and various other vested interests love to push SIPs. And why not! It is in the interest of fund managers to get a steady stream of money to invest (and increase the assets under their management).

Under a SIP, the investor invests a fixed sum in a stock or a mutual fund regularly preferably over long periods. The logic behind a SIP is that the investor buys more units of the fund when the markets are down and less when markets are up. Over time, a SIP is supposed to generate superior returns for the investor.

In one of my previous blogs, I had given some empirical evidence showing how a SIP is in reality an inferior investing strategy (http://shashankjogi.blogspot.com/2008/07/comparing-5-investing-strategies.html). It generates lower returns and yet is subject to the same kind of risk and volatility.

Why?

There is one important aspect of investing that a SIP misses out on. And it is an exit strategy. There is no mention of selling in a SIP. In reality, it is selling that counts! Intelligent selling is the key to above average returns. Why is selling so important even if you are a long term investor? Here is an example that clarifies this matter.

Look at the following annual returns in 2 portfolios:
Portfolio A: 15%, -5%, 100%, -40%, 10%
Portfolio B: 15%, -5%, 100%, -10%, 10%

A rupee invested in portfolio A would become 1.44 after 5 years. This implies an annual return of 7.6%
Similarly, a rupee invested in portfolio B would have become 2.16 after 5 years, implying an annual return of 16.7%

Now note the annual returns of the 2 portfolios. In 4 out of the 5 years, the returns are exactly the same. In year 4, portfolio B managed to avoid large losses achieving a loss of 10% compared to a loss of 40% in portfolio A. Just one year made all the difference!

In one of my earlier blogs I had discussed how downside volatility in returns is harmful for your portfolio (http://shashankjogi.blogspot.com/2008/07/avoid-price-volatility.html). Investors seeking above average returns should try to cut out such volatility from their portfolios.

So how do we cut out large downsides in our portfolio? Typically, although not always, large negative returns occur when markets run up excessively and become expensive. Be it in 1992, 1994, 2000 or 2008, valuations get very expensive and what follows is a crash. If an investor can stay out of most parts of the crash, he/she would be able to avoid large losses, and hence be able to generate significantly above average returns.

Returning to our focus on SIPs, SIPs do not require the investor to sell. Hence in a SIP, an investor's portfolio is subject to large downsides that the markets undergo when the process of expensive to reasonable occurs.

Instead, let us modify our SIP investing approach. We maintain our discipline of investing regularly using a SIP when the markets are not expensive. If they get expensive, we sell all our holdings and wait on the sidelines with cash. When markets correct and stocks become reasonable again, we restart the SIP. (One can use many methods to determine what is expensive and what is reasonable).

So what does empirical evidence suggest?

I looked at data on the BSE Sensex from 1995 till September 2008. I set up a SIP investing the same fixed amount every first trading day of the month. I set up a simple criterion for establishing when markets are expensive (to sell all equity holdings) and when they become reasonable again (to restart the SIP again). Lets call this a modified SIP. Then I compared this with a normal SIP without any selling decision.

Standard SIP: CAGR = 14%
Modified SIP: CAGR = 22%

And the modified SIP made only 2 selling decisions over a 13 year period! Practically no short term capital gains. So no tax liability! And the volatility and equity swings in a modified SIP turns out lower than those in a regular SIP.

(I could send the details for those who are interested)

How does a difference between 14% and 22% shape up over 20 years?
On an initial investment of Rs. 1 lakh:
At 14%, Rs. 1 lakh becomes Rs. 13.74 lakhs
At 22%, Rs. 1 lakh becomes Rs. 53.35 lakhs, nearly 4 times that at 14%!

A few simple sell decisions can convert a mediocre return into a excellent return with very significant difference in the end result for investors.

Clearly, investors should sell. While this is the most obvious statement one can make about investing, many investors do not sell. And SIP investors do not sell either.

Incorporating a selling discipline in a SIP can significantly boost returns. The modified SIP looks like a better approach to systematic investing than the conventional SIP advisors love to push.