Why stock SIPs are risky

AARATI KRISHNAN | Updated on December 26, 2011

Not all financial market innovations benefit investors. When applied to the wrong products or clients, some of them can, in fact, do more harm than good. The concept of systematic investing falls in this category. Used in equity funds, systematic investment plans (SIPs), which allow you to invest in a fund through fixed monthly instalments, work brilliantly. However, the same concept applied to individual stocks may materially peg up the risks to your portfolio.

Stock SIPs

With mutual fund SIPs taking off, many brokers and trading platforms today offer SIPs in individual stocks. They allow you to accumulate a stock by buying it at a daily, weekly or monthly frequency, based on standing instructions. You can set up SIPs based on the number of shares or a specific value to be invested per month.

Why do investors prefer SIPs at all? Consider how SIPs actually help improve returns from equity funds. Most of us invest in equity funds because we believe that they will deliver better returns than most other avenues over the long term. However, the problem is that stocks don't deliver that return in an orderly fashion. As markets are punctuated by runaway bull and bear phases, your entry point into equities makes all the difference to returns. SIPs, by phasing out your investments, help you avoid investing at market peaks and help you benefit from corrections after your start date.

Concentration risks

Having said this, why should SIPs work well for equity funds, but not for individual stocks? That is on account of two factors. One, SIPs in an individual stock may result in portfolio concentration. SIP investments result in your accumulating large exposures to a single asset. A five-year SIP of Rs 5,000/month in an equity fund will add up to investments worth Rs 3 lakh at the end of the period, based on cost alone.

Given that a fund, in turn, holds a diversified portfolio of stocks, this may be an acceptable holding for a Rs 15 lakh portfolio. But what if you bought Rs 5,000 worth of a single stock every month? At the end of the period, a fifth of your portfolio would be invested in it, a risky proposition. Investors may not readily recognise the concentration risks posed by stock-SIPs, because it is easy to lose track of your purchases when you make monthly investments.

The second risk arising from stock-specific SIPs is that you could well be betting on the wrong horse. By automating your investments, SIPs force you to accumulate more and more of an asset without checking back on it. But such an auto-pilot approach to individual stocks can be fraught with risk, especially in today's environment, where a regulatory change, a recalcitrant client or even a blip in the Rupee can cause a drastic shift in a company's fortunes. This logic would apply to a stock that does exceedingly well too. With a SIP, you could end up blindly adding to a stock as its valuations get richer and richer.

Finally, no matter how savvy the investor, stock selection is a game of chance. While some stock choices may turn out extremely well, others may fall flat on their face. Making big bets, month after month, on just 5 or 10 stocks of your own choice can subject your portfolio to considerable damage, if many of your choices turn out to be lemons. With the investments on autopilot, monitoring and rebalancing such a portfolio on an ongoing basis will be an uphill task too.

Work well in portfolios

SIPs, on the other hand, are likely to work quite well if applied to a complete portfolio. Investing a fixed sum every month ensures that you buy more units when markets fall and less when they rise. The real advantage of using SIPs in an equity fund is that you are not buying the same set of stocks every month.

Whether stock prices fall or rise, the fund manager is likely to be closely monitoring the portfolio and replacing stocks at regular intervals. Those who don't put much faith in active managers can take the SIP route to an index fund. In that case, your portfolio returns will be hitched to the fortunes of the broader market and will not rely on luck alone!

Published on December 03, 2011

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