How to invest systematically

It's clear now that markets seem unable to muster what it takes to sustain an extended rally. That is not to say that corporate fundamentals have soured overnight and the country's GDP growth prospects have nose-dived.

Far from it, the country's growth trajectory is very much on course. So when shall we see all this translating into stock market returns? Today, this is the question foremost on the retail investor's mind.

If the retail investor could unravel the vagaries of stock markets with as much ease, he might as well take up a job in a stock brokerage house. The truth is most investors have never had it good when it comes to reading the markets.

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In March 2003 when the Sensex was enticingly placed at 3,000 levels, it was too low for them. A year later when the Sensex rocketed past the perilous 6,000 mark it was good enough for them to invest in equities. Now after the market is nearly 25 per cent off its all-time high, investors are getting increasingly jittery and don't want to touch equities even with a barge pole.

So we have come full circle from last March 2003. Like then, equities are at relatively attractive levels, but investors are content at sitting on the fence until the market shows them some direction (i.e. until they move a lot higher). It is evident that investors never seem to be able to forsake their old habit of buying high and selling low.

To unravel this inconsistent behaviour, Prashant Jain, head-equity, HDFC Mutual Fund, drew an interesting parallel between real estate and gold investors on the one hand and equity investors on the other.

The former buy real estate/gold when prices are low because they look at these investments from a long-term perspective (at least 10 years). Opposite is the case with the equity investor who tends to buy high because lower equity prices scare him! Lower stock prices must actually be interpreted as an invitation to invest because the perceived risk at those levels is often lower than the inherent risk.

The moot point is -- how do retail investors discern the highs and lows well enough to make a 'killing' in the stock markets. This skill better known as 'market-timing' has no known rules and conventions that enable its proponents to acquire sure-fire mastery.

In other words, market timing is a lot like shooting in the dark, there is no reliable measure to succeed at it every time. When often investors do manage to enter at the bottom, or exit at the peak of a rally you can be sure it is pure chance and there is zero skill involved.

In other words, if it's happened once it won't necessarily happen again. Ask the thousands of investors and analysts who have burnt their fingers by acting on this premise.

So is there a way to take care of the 'market-timing' problem? Thankfully, there is a solution and its called 'rupee-cost averaging'. Complicated as it may sound, 'rupee-cost averaging' is an investment strategy that combines simplicity, risk reduction, and affordability. It's an ideal way to space out one's purchases and avoid paying too much.

A big advantage of rupee-cost averaging is that it takes the guesswork out of deciding when to buy. It does not burden the investor with timing his investments and over a period of time it helps him diversify his investments.

Investing systematically

Under rupee-cost averaging an investor typically buys more of equities or an equity-linked instrument like a mutual fund unit when prices are low. On the other hand, he will buy fewer equities/mutual fund units when prices are high.

This is a good discipline since it forces the investor to commit cash at market lows, when other investors around him are wary and exiting the market. Investors may even be pleased when prices fall because the fixed rupee investment would now fetch more units.

When investors understand this investment rationale, they will actually look forward to a market fall!

In our illustration we have taken an investor who avails of rupee-cost averaging through the systematic investment plan (SIP) offered by most fund houses. At a higher NAV (in Feb 2004), the investor purchased fewer units. Conversely, at a lower NAV (May 2004) the investor bought a larger number of units.

The investor can really ride the downslide in the NAV by increasing his SIP investment. For instance, if an investor had doubled his investment (to Rs 1,000) in May, his cumulative investments would have jumped to 313.7 units (from 251.2 units).

For rupee-cost averaging to be a success, stock prices and therefore mutual fund NAVs must push lower over time. Fortunately for the investor, this is a long-term phenomenon and the investor need not be too concerned about short-term blips.

One of the problems encountered when applying an averaging strategy to individual stocks is that there's a much greater possibility that stocks may fall in price and never recover, especially if the company's growth prospects are suspect.

Mutual fund investors do not have this worry since they own a diversified equity portfolio. Few funds have been long-term losers, and they aren't too difficult to spot.

Rupee-cost averaging works even better if the investor has the discipline to increase his SIP investments during a downturn in the markets (as explained in the illustration). That's when one can take advantage of rock bottom prices, which will further reduce the average cost and enhance returns.

When establishing a program, the investor needs to consider the frequency of his SIP investments - monthly, quarterly, semiannually, or any regular interval. More frequent intervals increase the investor's chances of buying units when prices are especially low.

SIPs will appear particularly appealing to investors who have lost money in the stock markets by investing at all-time highs. The mistake made by such investors was that they invested in a lump sum instead of spreading their investments over a time frame.

With an SIP, the investor writes post-dated cheques for some months/quarters over a pre-determined time frame. Even the amount is selected by him. To that end, most fund houses in the country are very flexible. They allow investors to begin an SIP with as low as Rs 500 on a monthly/quarterly basis.

This proves to be lighter on the wallet vis-à-vis lump sum investments.

Investors who would like to see how SIPs work more efficiently vis-à-vis the one-time, lump sum investments should note the illustration below, which involves a diversified equity fund from a leading domestic asset management company.

Taking the SIP route

As is evident from the above table, over the 3-year and the 5-year time frames, investing through the SIP route has proved to be more lucrative than one-time lump sum investment. Ideally, if you have an SIP going for at least 3 years, you are most likely to witness at least one bearish phase that will ensure you accumulate a lot of units at lower prices.

If N Prasad, chief investment officer, Sundaram Mutual Fund, is believed, '2004 is likely to be a normal year where there could be ups and downs and volatility. The one-sided secular run, which we saw in 2003 is unlikely to be repeated.' So that's good news for the savvy SIP investor.

Another carrot for going the SIP way has come from fund houses themselves. A lot of fund houses have been raising the entry loads on their schemes. What this means to the investor is that a slightly higher component of his investment monies will go towards meeting the fund's expenses -- in other words his disposable investible assets will decline.

That is the bad news. The good news is that fund houses waive off the entry loads (as high as 2.50% in some cases) for investors who opt for the systematic investment plan (SIPs).

Regardless of its pitfalls (and there aren't many) a systematic investment plan can certainly work to the investor's advantage over a period of time. Moreover it makes the investor indifferent to market shenanigans, so long as his investments swell over the investment period.

And most importantly, rupee-cost averaging adds a lot of focus to the investment strategy!

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