SIP

Introduction

A Systematic Investment Plan is what financial theory recommends for the average investor. These typically involve making small but continuous investments every few days (or every month) in a predefined instrument - typically a mutual fund. The amount to be invested depends on the financial plan of the investor and the market prices explicitly are not used. This is completely opposite to what "common sense" recommends.

Here, I look at SIP in more detail and try to explain some of the theory behind them.

Timing

It seems self evident to the average investor that what matters in financial markets is timing. Basically one makes money by buying low and selling high. Everyone always knows someone who made a fortune by buying the right stock at the right price. By extension, the average investor tries to get the timing right and hopes to make his own small fortune. Unfortunately, most lose out on this.

In order to see the problem with the above reasoning, one only needs to generalize it to everyone. Every single person in the market is there to make money. So everyone is trying to buy low and sell high. So if you think that the prices are low and buy a stock, someone else MUST think that the prices are high and hence is selling to you. Who is right? Typically, there are a large number of banks that do most of the trades so the changes are that the person who is selling to you is a large bank with dedicated analysts and trader who have put in much work into guessing whether the prices are high or low. So they are more likely to be right. Hence the average investor is likely to lose.

Information

In fact, there is a very different way to look at how markets function. Trading profits can be viewed as rewards for information. In other words a person who knows something new that the market does NOT know (like the fact that a certain company is going to win a large contract) can use this information to make a profit (for instance by buying stocks of the company and waiting till the information becomes public). Unfortunately, it is VERY difficult to know what the market knows and what it does not. Someone else may have known about the contract and he may have purchased a large amount of stock leading to increase in prices so even after the news becomes public (and the other person sells his stock) there is no significant increase in prices.

The question that every investor must ask himself is - whether he really has some information that the market does not have? Typically the answer would be no.

Investment v/s Trading

A person who makes money in a short time from new information is a trader. One who has money and time but no information is an investor. An investor must not expect "super normal" profits (which a trader does); if he does so he will likely have losses.

So now the question is - what should an investor do? An investor must stay clear of trader; since this is not really possible, the idea is to never invest in one stock at one time. Instead,

1. Invest in a basket of stocks
2. Invest over a period of time

The above two ensure that positive and negative effects balance each other leaving the investor with normal profits and minimum risk. The above two directly result in the concept of a SIP.

Practical Advise

1. Get a demat, trading and netbanking account so that you do not have to rely to brokers and intermediaries. The cost of the accounts is trivial.
2. Figure out a good mutual fund. A good mutual fund is one that has low management fees and follows a broad index rather than trying to be "too smart".
3. Figure out the total money you want to invest over the next year or so.
4. Start a SIP with monthly investments that are roughly one twelfth of your yearly target using you r trading account.
5. Bonus - If you feel that the SIP fees are too high (typically 100-150 Rs), you can save the same by manually making the trade on the pre-decided date every month.

ETFs

Introduction

I love ETFs. They are my preferred financial instruments of choice. And within ETFs, I prefer index funds. I prefer purchasing ETFs via SIPs - both ICICI and HDFC trading accounts allow that for a pretty small fee.

Terminology

• ETF: ETF is short for Exchange Traded Funds. These are just like mutual funds with one major advantage - in mutual funds, you can only sell back the units to the fund. In ETFs, these units can be bought and sold in the market just like any other stocks. Further derivatives (options and futures) on ETFs are also available and can be bought or sold.
• Active strategy: An active strategy tries to increase returns by trying to time the market - basically buy when the market is low and sell when it is high.
• Passive strategy: A passive strategy is a simple buy and hold. A basket of shares is created and then it is held for a long time (often several years) without any changes.
• Index: An index (like the BSE Sensex or the NSE Nifty) is basically a basket of stocks in a certain ratio. The index value is basically an average of the prices of the stocks weighted by the ratio in the basket.
• Index funds: These are mutual funds that track a certain index. In the best case, they purchase stocks in the same ratio as the index. Often, however, they purchase a subset of the stocks in a different ratio but these are so chosen to closely monitor the index.
• SIP / SEP: A SIP is a systematic investment plan while a SEP is a systematic equity plan. Basically these involve buying a small amount of stocks of units every few days (or every month) rather than all at once.

My reason for preferring ETFs are that they combine high returns with low hassle and good liquidity. Readers of my earlier post on liquidity will understand why it is so important. Unfortunately, it is very difficult to combine liquidity with high yields. Index fund ETFs are the closest that we get to the ideal.

Returns

First, let us look at returns. Elementary finance teaches us that the best risk-return ratio belongs to index funds - basically nobody can beat the market. Why that is so is the subject of another blog post but take it as gospel for now. This gives us the following rules of thumb

1. Mutual funds are better than individual stock.
2. Market index funds (like Nifty) are better than sectoral funds.
3. Passive strategy is better than active strategy.

The first is obvious since individual stock prices vary very much and so are risky. The second is a simple corollary. The third is surprising because EVERY mutual fund will say the opposite. What they do not tell you is that the charge for active strategy are high than for passive strategy so they have a vested interest in be-fooling you.

My preferred ETF - the NiftyBees (by Goldman Sachs) has an annual charge of only 0.5%. By contrast most mutual funds charge between 1-2%. Over a 20 year period, this itself will result in a 12-40% difference in returns.

Liquidity

Since ETFs can be traded, you can sell them via a trading account and get the money in 2 days. Hence, in case of an emergency, you will have cash in 3-5 days. Further, since they are index funds, you will not lose significantly due to market volatility.

Hassles

If you have a demat account, a trading account and a netbanking account, starting ETFs is a 2 minute job once you have decided on the ETF and amount. I suggest investing via SIP / SEP You just need to log into your trading account, go to the section on SIP / SEP, enter the ETF, the quantity and frequency and press enter. Every month, the set amount of units will be purchased and your netbanking account debited with the money.