A SIP that factors in short-term price movements

Systematic Investment Plan (SIP) offers an optimal solution for mass-affluent investors, as it enables them to take pre-defined exposure to desired asset classes and styles. Discerning investors do not, however, prefer SIP because it does not consider short-term price movements while taking exposure. The question is: How can investors take pre-defined exposure to asset classes, yet be sensitive to short-term price movements?

This article explains SIP and why it is optimal. In then shows how a modified rule helps investors retain the benefits of SIP, yet adjust exposure to short-term price movements.

SIP helps investors moderate several behavioural biases. For one, it helps investors moderate regret aversion. This refers to a bias that prompts investors to either avoid taking exposure to equity or significantly reduce equity allocation because their previous experiences in timing the market resulted in losses. For another, SIP offers a systematic way to save and invest. This assumes importance because investors often do not save enough to meet their investment objectives.

It is important to understand that SIP is not the same as Rupee Cost Averaging (RCA). The latter assumes that the investor has lump-sum money but chooses to spread the investment over a period of time. SIP, on the other hand, applies to an investor setting aside money from current income.

The problem with SIP is that it does not consider short-term price movements. Suppose an investor starts an SIP of Rs 5,000 to invest in a Nifty Index Fund on the fifth of every month. If the Index moves up 10 per cent in, say, May, the investor would obviously buy lesser units in June because of the increase in Net Asset Value during May. But the argument is that an investor is still committing the same capital (Rs 5,000) in an asset that may be overpriced.

Can SIP factor-in short-term price movements such that the investor commits more capital during price declines and less capital during price uptrend?

Dynamic SIP

Suppose an investor sets aside Rs 10,000 every month to invest in an index fund — we call this the committed capital. If the Nifty Index returned 5 per cent in the first month, the investor would adjust the committed capital by a factor of 0.96 in the second month to consider the short-term price movement.

The rule is as follows: The investor has to make an assumption about the expected investment return. We assumed that the Nifty will return 12 per cent in a year; that translates into one per cent per month.

If the actual monthly return is 5 per cent, the fund has outperformed monthly expected returns by 4 percentage points. So, part of the committed capital for the second month is now provided for by “unexpected” capital appreciation in the previous month. The investor, hence, deducts the “excess” returns and commits only the balance capital in the second month (0.96 times the capital).

This process enables the investor to commit lower capital to seemingly over-priced assets. Of course, it also requires the investor to commit more money when the asset price declines.

The cash flow adjustment comes from a side pocket account that the investor has to create. When the actual investment is less than the committed capital, the side pocket has cash inflow and when the investment is more, the account has cash outflow. The amount in the side pocket should be kept in money market funds to ensure high liquidity with near-zero capital risk. We call this entire process Dynamic SIP.

Dynamic SIP has its issues. For one, forecasting return is not easy. Besides, assuming uniform monthly return may not always be realistic. For another, side pocket account may not always have money to invest in additional units. To moderate this problem, investors should re-set actual investment to the committed capital at the beginning of each financial year. Dynamic SIP works well in a volatile market, as it cuts SIP investment when the market moves up and increases investment when price declines. It, thus, allows investors to make pre-defined dynamic investments.

(The author is the founder of Navera Consulting, a firm that offers wealth-mapping and investor-learning solutions. He can be reached at >enhancek@gmail.com )

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