The real benefits of a Systematic Investment Plan

Let me start by sharing what a prominent investment portal has to say about the benefits of opting for a Systematic Investment Plan (SIP).

“Systematic Investing in a Mutual Fund is the answer to preventing the pitfalls of equity investment and still enjoying the high returns. This SIP Calculator will show you how small investments made at regular intervals can yield much better returns over a long period of time.”

I recommend treading with caution while relying on such supposed advice. 

Systematic Investment Plans are a key part of the efforts made by fund houses to attract investors towards equity funds.  A number of financial advisors and investment portals also encourage investments through SIPs.  However, as I see it, a lot of the stuff out there necessitates reading between the lines, and filtering fact from fiction.  The quote at the start of this post is just one example of this.  Opting for a SIP can, indeed, be beneficial, but not in the way that this portal would have us believe.

For those of us who rely on the regular income from our profession to build wealth, a SIP is a convenient and effective way to invest regularly.  In an earlier post, I had mentioned that the wealth that we build is influenced by the amount that we save, the timeliness of our investments and the quality of our investment choices.  In my previous post, I had built on this to make a case for saving more and investing regularly.  This is a useful framework to understand the importance of a SIP.  It is a means to channelize, in a timely fashion, the amount we choose to save, into the funds that we choose. 

In other words, we are responsible for our investment choices and the amount that we invest; a SIP has no role to play in that. Furthermore, merely opting for a SIP cannot compensate for poor investment choices, or for a lack of thrift.  It is up to us to decide how much to save and how to allocate this between equity funds and debt funds.  A SIP ensures that we will not delay investing and will, thus, use time to our advantage.  Therein lies its importance.

SIPs can also be beneficial for those of us in a dilemma when deciding to invest a large sum of money into equity funds (or anything that is susceptible to frequent, steep price fluctuations).  Such dilemmas exist because of the uncertainty attached to the price- Is the current price a good price to invest at?  Or is it better to wait for the price to fall?  In effect, we have three choices:

1. Invest this at one go, now
2. Invest this at one go, on a later date
3. Invest this in smaller tranches, over a period of time

There is no basis for anyone to say for sure, as to which of these choices will result in the best returns.  We will only know in hindsight which course of action would have been the best.  Some of us may be inclined to take a call on the price movement and, hence, go with the first or the second option.  Those of us who would like to hedge out bets would opt for the third choice.  A SIP (or a Systematic Transfer Plan) is a convenient way to exercise this third choice.   It may or may not yield better returns as compared to the first two choices, but in all likelihood, it will enable us to sleep more peacefully.

A case for saving more and investing regularly

In my previous post, I had talked about three factors that contribute to the wealth that we build, namely

• The amount that we save and invest
• The timeliness of our investments (i.e. regular investing, without delay)
• The quality of our investment choices

I also mentioned that in my experience, far too many of us focus our attention on the quality of investment choices, losing sight of the first two factors.  In this post, I would like to make the case that while it is important to make good investment choices, it is far, far more important to save and invest as much as we can, and to invest regularly, without delaying our investments.

Time is money

The time that we stay invested has a strong influence on the wealth we build.  Procrastination, or even a tendency to wait for a better time to invest, can rob us of the opportunity to fully use time to our advantage.  The impact that this has on our potential wealth is such that to compensate for any delay, we need to earn a rate of return that is disproportionately higher, and which may not be achievable.  Let me demonstrate this with an example.

Let’s say that a person has a financial goal that needs to be accomplished 10 years from today.  Towards this, he invests an amount of 100,000 each year, starting today, for 5 years.  After that, he makes no further investment, and holds his accumulated investment.  Let’s say that this grows to a value of 900,000 at the end of 10 years from today.  This means that his investments have delivered a compounded return of 7.55% p.a.

Let’s now look at a scenario where he delays his investments by 5 years.  For his investments to now grow to a value of 900,000, he has to earn a significantly higher return of 20.28% p.a.

No matter what numbers we take, or how good be our investment choices, any delay in investing will require an unequally higher increase in the rate of return to compensate for that delay.  This may even need us to take far more risk than is desirable, or we may be comfortable with.  This makes the case for regular investing, which is widely regarded as the best antidote to procrastination.  There is far more truth to the saying, “The best time to invest is when you have money,” than a number of us realize.

Our savings are the most controllable factor

The amount that we save has a direct bearing on the wealth that we will build.  Any increase in our savings will proportionately increase the wealth that we will build, all else remaining the same.  Saving more can also help reduce the rate of return needed to meet our financial goals.  Its greatest significance, relative to the other factors, is the degree of control that we have over it.  Let me explain.

There is a practical limit to the rate of return that we can earn from our investments on a sustained basis.  For instance, in a country such as India, it would be very difficult to earn more than 15% p.a., year after year, or over a lifetime (some may even question our ability to earn anything close to that). 

In contrast, the amount that we can save, has fewer constraints, largely because it is linked to the earnings from our profession.  There are no limits to the potential of professional earnings.  It is up to us to seek out a line of work offering greater opportunities to enhance our income with lesser threats.  It is up to us to be in an occupation where there is a good match between our strengths and the requirements of the field.  It is also up to us to decide the share of savings to our income.

In case you find that hard to buy, you may like to check out the book, “The Millionaire Next Door.”  In it, the authors mention seven common characteristics that they identified among those who had successfully built wealth.  One of these was that they all lived well below their means.  Another was that they chose the right occupation.

Let me now put all of this together and summarize my case.

Our ability to save more and invest regularly will have a significant influence on the wealth that we build.  Saving more and investing regularly can bring down the rate of return we need to earn on our investments while not doing so can need us to take far more risk than is desirable, or we may be comfortable with.  Thus, while it is important to make good investment choices, it is far, far more important to save and invest as much as we can, and to invest regularly, without delaying our investments.

Life and Investing

Beyond the often-cited need for returns or safety of our money, there is a bigger purpose to investing in our lives.  The clarity to see investing in the context of life can help us make better investment decisions.  This post offers a perspective on this for those of us who are working and haven’t yet retired.

Most of us start our working lives with no wealth, dependent on the earnings from our profession.  As we move through life, most of us build wealth through what we save from the earnings from our profession, and invest.  Years later, when we retire from our profession or choose to take things easy, the wealth that we have built by then, will likely be the primary source of our income. 

Even so, some of us will retire out of necessity (brought about by age or an inability to earn income from our profession), while some of us will do so out of choice, on our own terms.  Whether we will, indeed, be able to be live life on our own terms, will depend on the amount of wealth we are able to acquire, relative to our need for passively generating income from it. If asked to choose between retiring out of necessity and retiring on our own terms, each one of us would prefer the latter. Logically, therefore, the acquisition of the wealth to be able to do so, should be an important (if not the most important) purpose for investing.

Equally logically, we need to understand what it would take to accomplish this goal.  No doubt, the quality of the investment choices that we make throughout our life will contribute to the wealth we build.  In addition, I’d like to submit two factors, related to investing, that will also play a crucial role: one, the amount that we save and invest, and the other, the timeliness of our investments (i.e. our ability to not delay investing).

In my experience, far too many of us focus our attention on the quality of investment choices, losing sight of these two factors.  While all three work best together, and not in isolation of each other, I believe there is a case to say that these two factors are individually more important than quality of our investment choices.  I hope to touch upon this in more detail in a future post.  For now, I’d like to offer the following thoughts:

For a number of people, savings are regarded as what is left over from one’s income, after factoring expenses.  In other words, for such people, paying for today’s expenses is more important than planning for future expenses.  I recommend flipping this around.  I believe that the wealth that we need to meet our future aspirations should determine our investment choices and the amount that we save, and not vice versa.  So long as our aspirations are reasonable, and we start investing early in life, it shouldn’t be difficult to find the right balance between our savings and our expenses.  Thrift and regular investing can also reduce the need for riskier investments, so to say.

While deciding our investment choices, we should diversify against the risk of our profession.  This risk is highest for employees having significant holdings of shares of the company they work for, or entrepreneurs keeping most of their wealth as capital in their business.  What if, something were to happen to the company one works for?  What if, something were to happen to one's business?  Limiting one’s exposure to one's business or the shares of the company that one works for, helps protect against this risk.

Looking at investing in the context of life is a key part of what is known as, ‘financial planning.’  Financial planners understand their client’s financial aspirations and then draw up a roadmap to translate these into reality.  Most even handhold the client on the way towards achieving these aspirations.  Chances are that your trusted financial advisor would be adept in the art and arithmetic of financial planning.  If not, you might like to ask around or check out the website of the Financial Planning Standards Board India.  They have the option to search through the list of financial planners registered with them.