The Hindu Business Line : SIP moderate fear; set-up equity tilts

Credit defaults, bankruptcies and now corporate governance - or the lack of it - have all injected extreme fear into the market. Small wonder then that more investors are now inclined towards bond funds than ever before. Such an asset allocation-tilt could lead to sub-optimal returns. The question is: Is there a strategy that can enable investors to moderate fear and take exposure to stocks?

This article shows that setting up a systematic investment account on index funds could be one such strategy. Such an account can help in ‘tricking the mind’ to distance itself from the investment. This will help investors moderate fear, which is an emotive response to short-term asset price declines.

Suffering myopia

Investors typically construct long-term portfolios. Often, however, they are swayed by short-term price movements. Such behaviour can be sub-optimal. Here is why.

Suppose an investor decides to construct a portfolio with a five-year horizon. Assume that this portfolio was set-up in 2007 when the stock market was trending up. Logically then, this portfolio would have suffered sharp drawdown, as asset prices tanked in 2008. But does this warrant a dramatic shift in asset allocation towards bonds?

When more money flows into the bond market, bond prices move up. Buying bonds at a higher price exposes investors to higher price risk. Moreover, the RBI is resorting to monetary measures to combat a possible economic slowdown. That would mean high interest rate volatility, translating into high price volatility.

Take the 10-year benchmark bond. Yields on this bond have fallen from 9.5 per cent last July to a less than 5 per cent early this month. The yields have since increased to 5.90 per cent.

Substituting equity exposure with bond funds only makes economic sense if returns in the bond market are likely to be higher. And that is not possible, especially for a portfolio with a 5-year investment horizon or more. The reason is that there is a cap on bond price movements - bonds cannot increase more than the undiscounted sum of their residual coupon payments and par value.

So, taking more exposure to bonds could be a sub-optimal decision. But what can make investors buy stocks amidst the financial chaos?

SIP It

Investors ebb with emotion when the stock market tanks. The reason is that portfolio drawdown is viewed as evidence for an investment decision that went wrong. And that leads to a once-bitten-twice-shy attitude towards stocks.

A systematic investment plan (SIP) on an index fund can moderate this emotion. Here is how:

One, the power of SIP comes from its creative cheating process. Investors can set-up automatic monthly debits from their bank accounts. This mechanistic process cheats the mind to distance itself from the investment. And that which is at a distance draws less negative emotion.

Two, the exposure is built gradually over a period of time at various price levels. This process of accumulation enables investors to acknowledge the fact that market timing is not a skill that all possess. A decline in asset prices may not, hence, draw a sharp negative emotion as will be the case with lump-sum investments.

Three, low-cost market (beta) exposure can be obtained through index funds. The advantage is that index funds provide exposure to large caps, which climb first when the market turns. The flip side is that the cap-weighted index construction exposes such investments to high price risk on heavy weights such as Reliance Industries, ONGC and Bharti Airtel.

Fourth, index funds are known to provide market returns, not excess returns over the benchmark. This minimizes the regret that comes from choosing an active fund that underperforms the benchmark.

An SIP on index funds fits well within the framework of core-satellite portfolio construct. An investor can hence build wealth without the need to time the market, as long as the investment is made religiously every month.

(The author is an investment strategist. He can reached at enhancek@gmail.com)

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