Should I discontinue my SIP?

January 28, 2009


Nowadays, a question that investors routinely pose to the Personalfn financial planning team is – “should I discontinue my SIP”. The downturn in equity markets has adversely affected the performance of equity funds. With portfolios languishing in negative territory, expectedly, investors are a worried lot. Some investors have concluded that now is a good time to discontinue ongoing SIPs. Is that the right strategy to adopt? Before discussing the same, let’s understand what an SIP (systematic investment plan) is and how it functions.

How an SIP works
Investing in a mutual fund via the SIP route entails making investments (often in smaller denominations) in a staggered manner as opposed to making one-time (lump sum) investments. This aids investors benefit from market volatility by lowering the average purchase cost. In an SIP, each installment i.e. a fixed sum of money is invested at the prevailing NAV (net asset value) on a predetermined date. In times of volatility, when the underlying fund’s NAV falls, it leads to a higher number of units being credited to the investor’s account.

For example, Rs 1,000 invested at an NAV of Rs 50, will result in 20 units being credited to the investor. However, should the NAV fall to Rs 40 in the subsequent month on account of turbulent markets, the investor will gain by receiving a higher number of units. In the process, the average purchase cost will fall as well.

An SIP investment makes market timing irrelevant. Timing markets involves attempting to make investments when markets are at their lowest and exiting at the peak. It’s a different matter that timing markets and doing so consistently is beyond most investors. By spreading investments over a period of time, the SIP mode does away with the need to time markets.

Finally, the downturn in markets has meant that several stocks are available at attractive prices. Also, the potential of the domestic economy to deliver over the long-term remains unchanged.

Now let’s come back to the original question – should investors discontinue their ongoing SIPs? Clearly, the discussion above suggests that now is the time to invest via the SIP mode, rather than discontinue ongoing SIPs.

The flipside
However, there is a need to understand that an SIP is a ‘means’ to achieve an end and not an ‘end’ by itself. In other words, the SIP should be aimed at helping investors achieve their predetermined financial goals. An SIP in isolation (i.e. one which doesn’t form part of a broader financial plan) or one in a poorly managed fund is unlikely to aid investors. The fund also needs to be right for the investor i.e. it should suit the investor’s risk profile and be equipped to aid him achieve his financial goals. Simply investing via the SIP route doesn’t eliminate the shortcomings of a fund or improve its prospects for the matter.

It is also pertinent that the SIP runs over a sufficiently long time frame. Often, investors are guilty of investing in a 6-Mth SIP, simply because, that is the minimum tenure offered by fund houses. Like investing for the long-term is pertinent in the case of equity investments, it is also important the SIP runs over the long haul i.e. at least 2-3 years. This can aid the SIP witness a falling market and deliver on the critical aspect of lowering the average purchase cost.


What investors should do
In conclusion, it can be stated that there is no standard answer for the query – should I discontinue my SIP? It would depend on the facts of each case. Although the benefits of investing via the SIP mode cannot be disputed, several factors need to be considered before making an investment decision.

For instance, investors who have the ability to take on risk, a sufficiently long investment horizon (at least 3-5 years) and are invested in funds that are right for them need not discontinue their ongoing SIPs. Conversely, others would do well to conduct a thorough assessment of their investments. The investment advisor has an important role to play in aiding investors with the latter. The key lies in not evaluating SIPs in isolation and thus making informed investment decisions.

The 1929 crash

In the previous article we had discussed the '1987 Crash'. A five-year 'bull' market, which started in 1982, came to an end in 1987.

In this article we will discuss the crash in 1929 which led to severe economic collapse during the early twentieth century.

The 1929 crash
After World War I, during the 1920’s, the American economy was fuelled by increased industrialization and new technologies. At the same time, a new concept of installment plans came into existence which gave birth to a culture of consumerism. With installment plans, American families could now afford to purchase more than ever before. America prospered in this decade and became the richest nation in the world. Aided by this spectacular growth, stocks were on a roll between 1921 and 1929; the Dow Jones Industrial Average rose six times during this period. Booming stock markets made people believe that the markets could only rise higher. Very soon this era turned into an era of intense speculation on the stock market.

But the exuberance started fizzling out by early September of 1929 as news about failure of several banks, lower housing projects and lower steel production started making headlines. The market peaked on September 3, 1929. At this point, the Dow was up 27% from the previous year. The prices started their downhill journey from here. On October 23, 1929 fear crept in and before the closing bell rang, stock prices suddenly plummeted. This event shook the beliefs of investors in the market and panic set in. The next day, prices further plunged and 13 m shares changed hands on a single day. That was the highest daily volume in the exchange's history at that point of time. The southward journey continued on the following Monday and the Dow registered a drop of another 13%. With no respite yet in sight, on October 29 the Dow dropped another 12%. The 1929 crash set off a chain of events that plunged the US and the world into a decade-long depression.

Economic woes further aggravated, as the government did not try to prop up aggregate demand. The Federal Reserve (FED) also did not use open market operations to keep the money supply from falling. Instead the FED raised interest rates and discouraged gold outflows after the United Kingdom abandoned the gold standard in the fall of 1931. And the FED let the private sector handle the Depression in its own fashion. This choked the economy and unemployment skyrocketed, companies incurred huge layoffs, wages plummeted and the economy went into a tailspin.

Conclusion
The stock market prices are based, in a great part, on expectations. Thus, in stock markets when investors believe stock prices will increase, it increases the demand for stocks. This increased demand continues until stock prices become too high in comparison to the intrinsic value of the related corporation. These overvalued stock price result in excess supply of stocks, which in turn causes prices to fall. When a lot of investors decide to leave the market at the same time then markets plunge and little can be done to prevent the markets from falling. Thus an investor should understand the dynamics of the markets and take it in their stride. As Peter Lynch quips "You get recessions, you have stock market declines. If you don't understand that's going to happen, then you're not ready, you won't do well in the markets."

The crash of 1987

In the previous article of this series we had discussed about the Asian Financial Crisis. The economies of Thailand, Malaysia, Singapore, Indonesia, Hong Kong, and South Korea, had witnessed impressive economic growth rates in the world during 1980 to 1990 but these Asian countries began to crumble in early 1997 and lost a decade of economic progress due to this crisis.

In this article, we will discuss the ‘1987 Crash’. A five-year 'bull' market which started in 1982 came to an end in 1987, between October 14 and October 19, 1987 and major indices of the United States dropped 30% or more.

The 1987 crash
After 1982 companies listed on the US bourses started posting strong gains but soon the price of stocks outpaced earnings growth, thereby inflating price to earnings ratios. This led to markets becoming overvalued. This prompted an influx of new investors, such as pension funds, into the stock market during the mid 1980s. The increased demand supported the inflated prices. Furthermore, favorable tax treatments given to the financing of corporate buyouts, such as allowing firms to deduct interest expenses associated with debt issued during a buyout, which increased the number of companies that were potential takeover targets helped in pushing up their stock prices.

By mid 1987 the macroeconomic scenario turned less certain. The trade deficit of the US grew significantly. In order to manage this deficit, the treasury Secretary James Baker suggested the need for a fall in the dollar on foreign exchange markets. This move led foreigners to pull out of dollar denominated assets which caused a sharp rise in interest rates. The legislation regarding elimination of tax benefits associated with financing mergers also added to the fear and stock market started sliding.

The trading mechanisms in financial markets were not able to deal with a large flow of sell orders. This added to the woes of the stock market. Furthermore, insufficient liquidity also played a significant role in the size of the price drop. Stock markets and derivatives markets also failed to operate in sync and played their part during the crash.

Conclusion
The global markets have become more complex than ever. While financial innovations and new technology are creating new opportunities, they are also increasing the scope of miscalculation and mayhem. In times such as these panic is inevitable and anything rash that investors do might make the situation worse. So the best advice one can give to investors is to stick with their long-term investment strategy, and take advantage of the markets’ volatile movements. Especially, in the current scenario, given that there is all pervading pessimism due to the global financial crisis, now would be the time to buy good quality stocks at bargain prices.

The Asian Financial Crisis

In the previous article , we discussed about the dot com bubble. Dot com companies believed that the internet business would somehow instantly take off and the entire business landscape will change in a very short span of time. The hype didn’t live up to its promises. Unfortunately, the growth of the tech sector proved to be illusionary and the dot com bubble burst in the year 2001. In this article, we will discuss about the ‘Asian Financial Crisis’, which engulfed most of the South East Asian countries in the 1990s.

The Asian Financial Crisis
The economies of Thailand, Malaysia, Singapore, Indonesia, Hong Kong, and South Korea, were posting some of the most impressive economic growth rates in the world during 1980 to 1990. Their Gross Domestic Product was compounding by 6% to 9% per annum during this period. A combination of inexpensive and relatively well educated labor, export orientation, falling barriers to international trade and heavy inward investment by foreign companies led to this impressive growth.

The wealth created by these countries fueled an investment boom in commercial and residential property, industrial assets, and infra-structure. However, this unprecedented investment boom was mostly financed with borrowed money. Furthermore, the investments were made on the basis of unrealistic projections about future demand. Very soon this resulted into significant excess capacity, which in turn led to a significant decline in prices. The companies that had made the investments started groaning under huge debt burden that they were now finding difficult to service.

By the mid 1990s, imports in these countries started growing dramatically, mainly aided by the investments in infrastructure, industrial capacity, and commercial real estate. This growth in imports moved the current account of their balance of payments into the red. To make matter worse, most of the borrowing to fund these investments had been in US dollars, as opposed to local currencies.

The growing deficits made it difficult for the governments of these countries to maintain the peg of their currencies against the US dollar. If that peg could not be held, the local currency value of dollar dominated debt would increase, raising a large scale default on debt service payments.

The Asian meltdown began in early 1997 in Thailand with a Thai property developer announcing its failure to make a scheduled US$ 3.1 m interest payment on an US$ 80 bn eurobond loan. This incidence raised the red flag and the Thai market started falling. Very soon the crisis percolated into the currency market. Thailand’s growing current account deficit and dollar denominated debt burden increased demand for dollars in Thailand and simultaneously decreased demand for Baht. Taking advantage of the situation currency traders began a concerted attack on the Thai currency. At that point of time, the Thai baht had been pegged to the US dollar at an exchange rate of around US$ 1=Bt 25. With this concentrated attack on Thai baht, the peg became difficult to defend. In order to defend the peg, the Thai government used its foreign exchange reserves to purchase Thai baht. The cost to defend the peg was US$ 5 bn, but Thai central bank had locked up most of Thailand’s foreign exchange reserves in forward contracts. Thus, Thailand only had US$ 1.14 bn available foreign exchange reserves left to defend the dollar peg. Ultimately, the Thai government had to bow down to the inevitable and the government allowed the baht to float freely against the dollar. The baht immediately started a slide. Following the devaluation of the Thai baht, a wave hit other Asian currencies and in a short spans of few weeks the Malaysian ringgit, Indonesian rupiah and the Singapore dollar all nosedived one after the other and the entire region was gripped by the crisis. These countries lost a decade of economic progress due to this crisis.

Conclusion
The region had been promoted by many as the future economic engine of the world economy. Investors have invested billions of dollars in the region on the assumption that the rapid growth of the last decade would continue. But it came grinding to a halt.

It once again proved that during periods of abundant capital, there is an often-irresistible temptation to anchor to false beliefs. This strategy may bear fruit for a while, but is costly over the long haul.

The dot com bubble

In the previous article we have discussed about ‘The Florida real estate bubble’ which started in the early 1920s, when Florida entered a period of frenzied real estate speculation. The bubble lasted for almost a decade and ended as the Great Depression began. Today we will discuss about the bubble that arose around the turn of the millennium – the dot com bubble.

The dot com bubble
The mid 1990s marked the beginning of a major growth of Internet users, who were viewed by companies as potential consumers. This prompted several entrepreneurs to venture into internet start-ups. These start ups came to be known as ‘dot coms’, as most of these companies had .com in their web addresses. At the pinnacle of the bubble many companies got engaged in unusual and risky business practices with the hopes of dominating their respective markets. Most of these dot com companies followed a policy of growth over profit. They assumed that if they built up their customer base, their profits would eventually rise. Investors responded to these risky business ventures with pots of money. With hundreds of companies being founded in a very short span of time, especially in tech hot spots like the Silicon Valley, the tech laden index NASDAQ rose dramatically during this time.

The euphoria was backed by the belief that internet business somehow would instantly take off and the entire business landscape will change in a very short span of time. However, no fundamental change was actually happening at the ground level. It was just wishful thinking on the part of companies that had no realistic business model to get these ideas off the ground.

The hype didn’t live up to its promises. Numerous high profile court cases regarding unscrupulous business practices started cropping up and the stock market began to tumble down. Unfortunately, the growth of the tech sector proved to be illusionary and dot com bubble burst in the year 2001. A decline in business spending combined with the market correction dealt a serious financial blow to many dot-com companies.

Conclusion
The internet caught the fancy of people in the 1990’s. This prompted many companies to promise life-altering changes. Though these ideas for change had a grain of truth in them, they were expected to deliver overnight instead of the decades they would actually require. The fundamentals of the dot com bubble were terrible. Most of the companies were not profitable and were having very risky business models. Some of them had no intention of ever making a profit. While the business model of these companies had no realistic way to turn a profit, their IPOs were skyrocketing just because of hype around them.

The burst of dotcom bubble once again highlighted the fact that the performance of a stock is dependent on performance of the company. As Peter Lynch says “I think you have to learn that there's a company behind every stock, and that there's only one real reason why stocks go up. Companies go from doing poorly to doing well or small companies grow to large companies.”

Warren Buffett on Market Fluctuations

From 1997 Letter to Shareholders:

A short quiz: If you plan to eat hamburgers throughout your life and are not a cattle producer, should you wish for higher or lower prices for beef? Likewise, if you are going to buy a car from time to time but are not an auto manufacturer, should you prefer higher or lower car prices? These questions, of course, answer themselves.

But now for the final exam: If you expect to be a net saver during the next five years, should you hope for a higher or lower stock market during that period? Many investors get this one wrong. Even though they are going to be net buyers of stocks for many years to come, they are elated when stock prices rise and depressed when they fall. In effect, they rejoice because prices have risen for the “hamburgers” they will soon be buying. This reaction makes no sense. Only those who will be sellers of equities in the near future should be happy at seeing stocks rise. Prospective purchasers should much prefer sinking prices.

For shareholders of Berkshire who do not expect to sell, the choice is even clearer. To begin with, our owners are automatically saving even if they spend every dime they personally earn: Berkshire “saves” for them by retaining all earnings, thereafter using these savings to purchase businesses and securities. Clearly, the more cheaply we make these buys, the more profitable our owners’ indirect savings program will be.

Furthermore, through Berkshire you own major positions in companies that consistently repurchase their shares. The benefits that these programs supply us grow as prices fall: When stock prices are low, the funds that an investee spends on repurchases increase our ownership of that company by a greater amount than is the case when prices are higher. For example, the repurchases that Coca-Cola, The Washington Post and Wells Fargo made in past years at very low prices benefitted Berkshire far more than do today’s repurchases, made at loftier prices.
At the end of every year, about 97% of Berkshire’s shares are held by the same investors who owned them at the start of the year. That makes them savers. They should therefore rejoice when markets decline and allow both us and our investees to deploy funds more advantageously.

So smile when you read a headline that says “Investors lose as market falls.” Edit it in your mind to “Disinvestors lose as market falls — but investors gain.” Though writers often forget this truism, there is a buyer for every seller and what hurts one necessarily helps the other. (As they say in golf matches: “Every putt makes someone happy.”)

We gained enormously from the low prices placed on many equities and businesses in the 1970s and 1980s. Markets that then were hostile to investment transients were friendly to those taking up permanent residence. In recent years, the actions we took in those decades have been validated, but we have found few new opportunities. In its role as a corporate “saver,” Berkshire continually looks for ways to sensibly deploy capital, but it may be some time before we find opportunities that get us truly excited.

In a Fire Sale Think about Entry, not Exit!

The old adage that the market operates on greed and fear has been well-exemplified over the past few months. It is never savory to witness paper losses, and there are few fears as strong as losing one’s hard-earned money in a violent, abrupt market correction. In an environment where FIIs have been selling their wares at fire-sale prices to meet margin calls and recapitalization requirements in their home countries (or to simply avert bankruptcy), it may seem that the time has come to book losses, exit the market and re-enter at a more opportune time. However, there are several logical reasons why it does not pay to overreact…read on to understand why.

1. Market Timing never wins

A natural human reaction to a sudden plunge in the markets would be to run for safety by reducing or liquidating one’s exposure. The base instinct is to stem loss of capital and eventually re-enter the market at a more favourable juncture. However, repeated studies have shown that market timing, i.e. trying to perfectly time entry and exit points, seriously damages investor’s long-term returns. As the historical long-term trend of the stock market has been upward, one must recognize that there are significant risks with trying to accurately time the market’s peaks and troughs in search of abnormal gains. This strategy typically results in:

i. High exposure to stocks at the peak of bull runs (just prior to a sell-off), and
ii. A reduction of holdings in a deep bear market, just before of a period of stellar appreciation.

Essentially, timing the market puts one at risk of selling low and buying high, and is a sure-fire way of guaranteeing disappointing returns. Perfectly timing entry and exit points sounds good in theory, but usually fails in practice. The direction of the market can change rapidly, and market rallies can occur suddenly and over very short periods. Further, attempting to move in and out of the market can be an extremely costly affair, particularly because a significant portion of the market’s gains over time tend to come in concentrated periods. Missing out on just a handful of the best-performing days in the market may leave investors at a significant performance disadvantage compared to investors who remain fully invested for the long-term.

2. Markets Do Recover

First, one must recognise that no two crises are alike. The paths that each crisis takes, and the institutions they decimate, are always different. In the current scenario, what started out as a boiling over of the U.S. housing market and over-extended banks resulted in a chain-reaction across the globe, claiming victims in diverse places from Russia and Iceland to Argentina. Volatile markets are by definition highly unpredictable, and a case in point is the U.S. Dollar. While one would expect that the currency of the country suffering the most would fall in value rapidly, the reverse has happened. The phenomenon of de-leveraging and unwinding of global assets by FIIs has resulted in huge demand from them for U.S. Dollars to repatriate back to their home countries.

The ensuing liquidity crisis in India, coupled with negative psychology and sentiment, has resulted in tight credit conditions across the economy. But history shows us that corporations learn to tighten their belts, governments induce liquidity and confidence-building measures, pricing re-discovery begins, and eventually the tide turns. Declines in the equity markets are not uncommon, and as mentioned previously, such periods of sudden turmoil have been normal occurrences in the market’s long-term upward trend.

3. Emotions ? Wealth Creation

Fleeing stocks for the safety of Gilts or CDs or Liquid Funds may seem quite appealing at times, especially when the market takes a sudden plunge on a negative news headline. In times of turmoil, it can be difficult to take a long-term view and resist the urge to react to the latest market swing. For short-term financial needs, cash and cash-equivalent investments can be good choices. However, they are not suitable for long-term wealth creation, because the returns are likely to be too low – your investments need to outpace inflationover time, otherwise your purchasing power is eroded. Historically, it’s been equities that have helped investors compensate for inflation by delivering higher average annual returns than cash or debt investments.

The need to keep an investment allocation policy constant is thus necessary for wealth accumulation. One can always alter the allocation to meet changing lifestyle needs and requirements, when it makes sense to revisit your investment plan due to meaningful changes in your life – the change should be driven by something significant and permanent. On the other hand, booking losses or making sudden, abrupt changes in line with market declines would not get you where you want to be. Keep in mind that 21st century technology and medical science advancements may help you live 80, 90 or even 100 years! With extended investment horizons the effects of inflation and the preservation of purchasing power need to be seriously considered. Staying calm can help investors avoid making moves they later regret. And emotional decisions more often than not lead to regrets.

4. Crisis = Opportunity Scale UP, not down!

To paraphrase the old sage of the markets, Warren Buffet, when others are fearful it is time to be greedy and vice versa. As painful as they are, market downturns can serve as reminders of the risk inherent in the market. It is precisely because stocks are a volatile asset class that they have historically provided a higher rate of return relative to other major asset classes, such as debt or cash. Market participants expect higher returns to compensate them for taking on additional risk. As a result, market fluctuations are the norm and not the exception, and short-term fluctuations are inevitable in the long-term upward trajectory of the market.

That is why some of the best periods to have entered the stock market have been during periods of particularly negative sentiment and extreme market turbulence. Hindsight suggests that during challenging economic episodes in history, investing more in stocks has been a prudent decision. While having the fortitude to stay invested provides an opportunity to fully participate in the market’s long-term upward trend, investing additional money has proven to be the kicker that can generate large returns in one’s portfolio. Waiting until sentiment feels positive again to make an investment has typically not been a good method of achieving future returns. Many of the best periods to invest in stocks have been those environments that were among the most unnerving.

5. Technicals vs. Fundamentals

When market technicals and perception start overriding the fundamentals, the question we ask is how is it that a large, blue-chip corporation is suddenly worth 20% or 30% less than a week ago or a month ago? Is the sell-off justified by the underlying economic and corporate fundamentals? Is the market becoming too pessimistic? Or is the sell-off in line with diminished expectations for economic growth, profitability and balance sheet performance in the coming months?

Whenever panic-induced selling begins, prices can become much cheaper than justified by their intrinsic value. This is the reverse of what typically happens in a hyper bull-market run. Valuations can become irrational on both the up-swing and down-swing. This is no doubt a tremendously challenging time for investors, but panics can cause prices to fall further than might be appropriate based on the underlying fundamentals. While nobody has a crystal ball to predict when exactly the bear market will turn around, you can be assured that as long as the entire world’s economy does not collapse overnight, it is low valuations that will eventually set the stage for the next bull-market rally.