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Three SIP myths to be cautious of

Given the rising popularity of SIPs, investors are falling prey to some misconceptions about SIPs. Here are three such myths

Three SIP myths to be cautious of

As the mutual fund industry celebrates record assets under management in June 2017, there's a new phenomenon that has contributed to this feat - the runaway popularity of systematic investment plans (SIPs). But as with all good investment ideas, SIPs have also fallen victim to hype and misconception. Here, we bust three common myths about this investment tool.

SIPs protect you from losing money
SIPs are not a separate asset class like bank deposits, equity funds or debt funds. They are only a method or tool to invest in the asset class of your choice. SIPs reduce the risk of capital losses in equity funds but don't eliminate it.

If you start an SIP at a market high and the market falls sharply after you began investing, you will lose capital even on an SIP investment. Value Research conducted a comprehensive study on the performance of SIPs across all diversified equity funds for the last 20 years recently. (Refer the May issue of Mutual Fund Insight for the detailed findings.) The study showed that it is only on SIPs that run on for four years or more that capital losses were a rare possibility. This again is a function of how equity markets in India have behaved. Because bear markets in the last two decades have never lasted for more than four years, SIPs too never made losses if continued for over four years.

Therefore, while investing in SIPs be aware that you still take on the risks of the asset class you are choosing. If you are doing SIPs in large-cap equity funds, there's some risk of a capital loss. If the SIP is in mid- or small-cap funds, the risk of that loss is higher. If you are running an SIP directly in stocks, there's an even higher probability of losses.

Start SIPs in beaten-down sector funds
Quite a few seasoned investors are enamoured of using the SIP route to invest in sector or thematic funds. But SIPs are, in reality, a very sub-optimal way to invest in sector funds. This is because sector funds, by their very nature, are designed to deliver returns for investors over short market phases of three-five years.

Stocks in a specific sector typically outperform the market when the sector is enjoying exceptional profit growth due to an upturn in the business cycle. The market then uses this opportunity to re-rate the valuation multiples of such stocks. However, after a three- or four-year spell of good returns, sector fads in the market usually fizzle out. A big meltdown then follows, wiping out all the previous gains.

Investors in sector funds, therefore, need to get their timing exactly right to capture this outperformance. They need to invest when the sector is beaten down and exit when the fad is at its peak.

Using the SIP route, however, works against this process. Just assume you think IT stocks are beaten down today and start an SIP in technology funds. The sector may be cheap when you kick off your SIP, but what's the guarantee that stock valuations won't run up even as your SIP is continuing?

The other problem with SIPs is that by putting your decisions on autopilot, they take away your incentive to track the markets closely. This can deplete your returns in sector funds. Before you know it, the sector may have peaked out and head downhill. So if you think IT or pharma stocks offer great value today, scrounge up the lump-sum money you can and invest it in these sector funds.

But if you lack the conviction to make this big bet, it is best to avoid IT or pharma funds altogether and stick to diversified-equity funds. No point in opting for a high-risk investment and then trying to hedge your bets!

Stock SIPs are better than fund SIPs
If SIPs work so well in mutual funds, won't they work even better with direct equity? After all, stocks can earn multi-bagger returns which few equity funds can deliver. That's an oft-heard argument in a bull market. In fact, many brokerages now offer daily or monthly SIPs on your favourite stocks.

Yes, stock SIPs can help average your buy price. But while signing up for them, you need to keep three checks in mind.

One, when you accumulate a stock via SIP, you can end up owning too much of it in your portfolio if you don't keep a careful watch on the individual stock or sector weights.

When you invest in a stock, the exposure you take to it usually depends on how bullish you are about its prospects and how it compares to the other holdings in your portfolio. However, it is harder to keep track of relative portfolio weights when you invest through SIPs as compared to lump-sum purchases.

Two, multi-bagger returns in the market come from identifying stocks that are undiscovered, entering them at low prices and then tracking the business closely to ensure that it is meeting expectations. SIPs, by nature, are designed to put your investment on auto pilot. This may work reasonably well in a fund, where the fund manager takes care of your portfolio. But when you do a stock SIP, close monitoring of returns on your part is essential to avoid bets that backfire.

Three, if you're a seasoned investor, you would know that no stock is a perpetual 'buy' at any price. Often, stocks or sectors that appear to be great buys at one point in time turn out to be avoidable just a few months later. When you sign up for SIP in a mutual fund, you are buying into a professionally managed portfolio, where the identity of individual stocks can keep changing. The fund manager actively reshuffles his bets at different market levels based on the options available. But with a stock SIP, it would be up to you to ensure that the stocks that you're regularly buying are good acquisitions over time. You will have to keep a close watch on both the company's performance and the sector's to ensure that accumulating it remains a good idea.

To sum up, SIPs are great investment tools when you use them wisely, stay the course and are fully aware of the risks of equity investing. But they aren't a magic pill that will deliver great returns, irrespective of the asset class or investment situation.