How to deal with loss-making SIPs

Jai and Veeru bumped into their college friend Gabbar after many years. As they made their way to the dhaba for a paratha lunch, Gabbar kicked off a chat.

Gabbar: Jai and Veeru, so happy to meet you two, yaar. I hear you both are wonderful investors now and I have something to ask you.

Jai: Oh! We are not high net-worth investors like you but tell us what it is about.

Gabbar: It's about my SIPs. Earlier I used to keep buying and selling stocks based on my brokers' tips. I couldn't even concentrate on my work as I watched the market all the time. So in 2017, I decided to give up this direct investing and invest only through SIPs in mutual funds. But they have let me down badly.

Veeru: Why do you say so?

Gabbar: Well, people told me that SIPs will protect my portfolio from losses. I have Rs90,000 to invest in equities every month. I have monthly SIPs running in five small-cap funds and all of them are showing negative returns of 15-19 per cent for the last one year. If I am going to make losses only, why bother with SIPs! I can make losses myself!

Veeru: Ha ha! Be happy you moved to SIPs, Gabbar. Some of those small-cap stocks which were tipped as hot favourites are down by 70-80 per cent in the last seven months. Your fund investments are only down by 15-19 per cent.

Jai: But jokes apart, someone has given you a completely wrong picture about SIPs, Gabbar. Who told you SIPs can't lose money? What SIPs do is to spread out your investment over time so that you don't end up investing everything at a market high. But while SIPs spread out your investments (and thus risk of investing at a bad time), they don't completely remove risk from equity investing. If the market falls below the levels at which your SIPs were invested, your current NAV will be lower than the NAVs at which you invested, right?

Veeru: Yes, actually, the main aim of an SIP is to average your costs of purchases downwards with each instalment. But in your case, SIPs have resulted in your buying into a rising market until January 2018. It is only from January this year, that your SIPs have worked as they should. They have averaged your cost downwards.

Gabbar: Then, are you telling me I was better off making a lump-sum investment?

Jai: Not at all, Gabbar. Who knew last year whether small-cap stocks would rise or fall? Probably, with your luck, if you had put in a lump sum, this bloodbath would have started in August 2017 itself.

Veeru: Ha ha, that's probable!

Gabbar: It's no laughing matter. I am wondering whether I should just stop the SIPs and reduce the pain now.

Jai: Don't be foolish, Gabbar. The cost averaging in SIPs works best when markets are crashing. Taking advantage of falling markets is the main objective of SIP investing. Now that small-cap stocks have been falling for six months, your fund managers will get better opportunities to buy good small-cap stocks cheap. That improves your chances of making much better long-term returns from your funds. If you look at the history of small-cap funds, you will find that the best five-year returns were made by investors who bought them in 2012-13. That's when everybody was running away from small-cap stocks. You are in a similar situation now.

Gabbar: I think I have chosen bad dates for my SIPs. My friend started SIPs at the same time and his one-year returns are still positive at 9-10 per cent. My SIPs are on the fifth of every month and my friend's are on the 15th.

Jai: Impossible. The dates cannot make such a big difference to returns on an SIP. If stock prices are falling continuously like they have been in the last six months, how is it possible that investment on one date is far better than another? That's like saying the Sensex rises on the fifth of every month and falls on the 15th. I've tried SIPs on all kinds of dates - fifth, 15th, 20th - in the same fund and I can assure you that the difference in returns is not more than a few hundred rupees in the long run.

Veeru: Is your friend also a small-cap fan? Which funds is he investing in?

Gabbar: No, no, he is much more cautious than me. He started SIPs in multi-cap funds. Actually, I am also having second thoughts about why I started all my SIPs in small-cap funds.

Veeru: Now, that's a valid doubt, Gabbar. What you are talking about is an asset-allocation choice. If you decided to put all your SIP money into small-cap funds based on their past returns, let me tell you it wasn't a good idea. The way you are reacting to a 15-19 per cent loss, I would say that a fully small-cap portfolio doesn't really suit your stomach.

Jai: Small caps are like the pickle to go with your parathas. Just because pickles give you a kick, you cannot have a whole meal of them. You'll get indigestion! Now that you've realised this, I would suggest starting SIPs in multi-cap funds and stopping SIPs in one or two of your small-cap funds. Decide to allocate a fixed part of your Rs90,000 equity money to small caps. You can think of putting Rs15,000 or Rs20,000 in small-cap funds and the rest in multi-cap funds.

Gabbar: Yes, that sounds better. But which SIP should I stop? Should I stop the one that's given the maximum loss in the last one year?

Jai: No, you would be making the same mistake again. Don't make any buy or sell decisions with mutual funds based on their past six-month or one-year returns.
Which is the small-cap fund in your portfolio which has the worst five-year or 10-year returns? Which one doesn't have an experienced fund manager? Those are the points to consider.

Gabbar: What about the money I've already invested in small-cap funds? Should I redeem it?

Veeru: Ideally you should because once you decide that you are comfortable with a 15 or 20 per cent allocation to small-caps in your equity portion, your entire portfolio must reflect that. But you can wait for your older investments to come back into green before making the switch. No big hurry.

Gabbar: I hope that happens in the next six months, Veeru. These losses are making me lose my appetite!

Jai: It can happen if you are lucky Gabbar, but don't bet on it. You know, small caps were in a bubble-like state before this crash. And when bubbles burst after a long spell of irrational valuations, stock prices can remain depressed for a long time.

Gabbar: That sounds quite worrying. How much time can it take then?

Veeru: Be prepared for four-five-years' time, Gabbar. But that's the time horizon you need to have in mind for equity investments in any case. You know, Mutual Fund Insight did this huge number-crunching exercise to study real-life SIP returns on equity funds for a 25-year period from 1992 to 2017. Taking all equity funds with a 10-year history, they studied over 3.67 lakh possible SIP accounts running from 1992 to 2017 across 217 schemes. In that study, investors who did SIPs across diversified equity funds for one year experienced losses about 22 per cent of the time. So, you should realise that there's nothing unusual or unlucky about making a loss in the first year of your SIP! But as they lengthened the period of the SIP, the chance of making that loss fell steadily. SIPs that lasted two years made losses 16 per cent of the times and three-year SIPs suffered losses about 10 per cent of the time. A four-year SIP had a small 6 per cent probability of losses. But if you continued longer than that, you were sure of a positive return.

So the message is quite clear, Gabbar. Don't worry too much about whether you've started your SIP at the right time or whether you've picked a lucky date. All you need to do is to get your asset allocation in order, continue with the SIPs and stay patient. It will surely pay off in five years' time.

Jai: In fact, the more the markets fall, the more you should be happy that you're doing SIP investing in mutual funds. As a shopper, don't you like to buy clothes and mobile phones at a discount? Think of this correction as a sale on small-cap funds.

Veeru: Also thank god you decided not to bet on stocks on your own and took your money out of those small-cap rockets that have crashed 70-80 per cent. Recovering that loss would have been much more difficult than getting back to green on your small-cap funds! At least here, the fund manager will sell out of the dud stocks and buy better ones. I know many investor friends who are stuck with such duds, Gabbar.

Jai: That proves you are lucky after all, Gabbar. Let's celebrate with some halwa.

Gabbar: Yes, that really brings back my appetite.