Apart from factors like loads (not there anymore), one of the most important factor that decide your returns is timing of entry and exit. Investor behavior is aligned towards starting equity investments when markets are touching new highs and exits when markets are touching lows. Even for individual portfolios, equity allocations rise when markets are high and decrease when they are low.
To avoid this behavior, a bright solution was SIP (systematic investment plan), where you invest a fixed amount regularly. The idea behind an SIP is regular investment and avoiding market timing. This smoothens volatility over longer periods of time. Technically, what the SIP does is help you lower your average cost in a falling market. But in a rising market you are buying lesser quantity for the same investment and thus the average cost goes up. Hence, the SIP performance measurement takes into account that investment is made at many points in time. On the other hand, fund returns are measured assuming you invested at one particular point in time and exit in another. This is why there is going to be a disconnect when SIP returns are measured against fund returns. Particularly in a growth market, which is on a long-term rising trend, single-point return is likely to be elevated because an SIP continues to invest as the market rises.
SIPs are hugely successful tools for enforcing savings discipline and should probably be called ‘systematic savings plan’. For first-time investors and those with low exposure to mutual funds or stocks, they are a simple and convenient tool. However, to extract maximum returns out of SIPs, it is critical not to exit in falling markets and if possible even enhance the amounts. If history is anything to go by, a large number of current SIP investors are likely to stop or reduce their SIPs when markets fall, which is counter-productive. This investment behaviour ensures that their cost will remain high and returns will be significantly lower than fund returns.
Let’s assume that Indian equity markets will give 13-15% returns over a long period of time—in line with historic returns too. However, if in the recent past (say 1-3 years), returns have been much higher than normal returns, it implies that markets are discounting future returns now itself. So, unless you believe that the long-term return trajectory has shifted (a very tough call to make), future equity returns for next 1-2 years are likely to be lower than in the recent past, and likely to be lower than long-term returns.
It is not unusual for equity markets to deliver returns before the earnings growth comes. If there has been a period of linear rise in stock prices, it may be followed by a period of correction. This is somewhat the situation at present. Corporate earnings growth is yet to show a meaningful uptrend but stock market has done well in the past 2 years. In such a scenario, should you be raising your exposure to an asset class where future returns are likely to be lower than in the past?
We are clearly at a point in the cycle where greed is the dominant sentiment. It is evident in the violent movement in small-cap stocks, aggressive pricing and huge over subscription of IPOs. Even though corporate earnings have been slow to pick up, stock prices have risen on the hopes of high growth in the future. Even if the expected growth occurs, most of it is likely already reflected in stock prices. So, we’ve already borrowed returns from the future. Markets are never rational and move from extreme pessimism to high optimism, implying that future returns are likely to be lower.
Longer term, equity remains the best asset class to be in, provided you remain invested when and during the market falls. The current period offers a tactical opportunity to possibly realign your asset allocation and book profits if your equity allocation has exceeded the original level. In case your equity weight is already low or you are a first-time investor, then any time is a good time to get started or remain invested. This column has been a strong votary of right asset allocation based on your investment horizon and risk profile. The right asset allocation and the discipline to stick to it during tough market conditions will align your returns with the fund or the benchmark.