Thursday, February 11, 2010

Riding the 'V'

In the last few weeks, there have been quite a few news articles on investing in company fixed deposits. Since my piece on Mahindra, some new companies have also hit the market with their deposits like Unitech and JP Associates. Here I would like to reiterate that as investors we need to be very careful of every issue and should deeply analyze the issuers / issue before we commit any of our hard earned capital.

In this blog, I am going to analyze, with the help of some data the pros and cons of an investment technique that has oft been written about and discussed in the investing world – Dollar Cost Averaging (also known as Systematic Investment Plan). At the end of the blog I would like to answer the question – Is dollar cost averaging helpful?

Simply put, dollar cost averaging means investing a fixed sum of money every period in a particular asset class. The benefits of doing this are the following:

1.It is simple and does not require you to be an expert on anything (stock market movement, GDP, interest rates, fiscal deficit, inflation etc)

2.It removes the emotional aspect of investing because it is mechanical and does not require you to think or react to anything

3.You end up saving a fixed amount every month which becomes a large sum later

4.It is a very passive and cheap way of investing

In order to verify the effectiveness of this technique I decided to look back at the Sensex for the last 10 years starting 1st Jan 2000. I took 10 years so that I would capture at least 1 full business cycle. What would have been the result if an investor had invested a fixed amount of Rs. 10,000 every month for the last 10 years starting 1-Jan-2000 into the Sensex? The results are below:

(click on table to enlarge)

The Table is divided into 3 parts – Part A, Part B and Part C. Part A lays out the performance of this Systematic Investment Plan (SIP), Part B lays out the performance of the Sensex and Part C compares the returns from the SIP and the Sensex.

Let’s look at Part A first. This part of the table shows the investment amount every year (Rs. 120,000 in this case), the number of units (or ‘shares’) of the Sensex that the Rs. 120,000 would have bought each year and its market value at the end of the year. For e.g. In the year 2000, the investor would have been able to purchase 26.2 shares of the Sensex whose value at the end of the year would have been Rs. 104,073 – a loss of 13.3%.

There is also a ‘cumulative’ column which shows the cumulative market value of the SIP at the end of every year. For e.g at the end of year 2 the cumulative market value of Rs 240,000 (Rs. 10,000 per month invested for 24 months) would have been Rs. 198,418 – a loss of 17.3% (the cumulative returns are in the purple boxes). As you can see the number of units bought varies considerably over the 10 years. In some years the 120,000 would have got the investor 37 shares of the Sensex (Year 2002) while in others it would have got him only 8 (Year 2007). This is an important aspect of dollar cost averaging.

Now lets look at Part B. Part B tells us what happened with the Sensex in those years. In the beginning of 2000 the Sensex was at 5,375 and closed the year at 3,972 – a fall of 26.1%. This table also has a cumulative column which shows us what the cumulative results would have been. For e.g At the end of year 2 (2001) Sensex had fallen by 39.3% from 5,375 to 3,262.

Part C simply tells us the difference between the SIP performance and the Sensex performance. In year 1 the SIP gave 12.8% more returns than the Sensex (-13.3% vs -26.1%). In year 2 that number was 22.0% and so on. At the end of 10 years, the SIP would have given a 199.6% return compared to 224.9% by the Sensex.

Now, if we plot the cumulative returns of the SIP with that of the Sensex year-on-year over the 10 years, we get the following graph:

This is a very interesting result because what it means is that this mindless investing technique would have beaten the benchmark index 8 out of the last 10 years! – A feat which 90% of highly paid highly educated highly cocky fund managers fail to accomplish.

Now, lets pause a while and analyze the numbers. The Rs. 12,00,000 invested in the SIP over 10 years would have grown to Rs. 35,95,109 or 2.99x the invested amount at the end of Year 10 (See Red Circles on the Table). Remember that this excludes dividends that you would have received over the 10 years. So, the actual returns will be higher than 200%. On the other hand, if you had invested in the Sensex on 1st Jan 2000 and sold on 31-Dec-2010 you would have ended up making 225% i.e. 25% more than the SIP.

However, to make that 225% return, the investor would have had to do a Rip Van Winkle for 10 years. For a normal person, it would have been emotionally torturing to see the Sensex go up and down day in and day out every day for 10 years. Imagine reading about it in the newspapers every day, watching it on television news channels and having dinner table conversations with your father /mother / uncle /aunt /brother / wife / friend.

Just think about how many things happened in the last 10 years economically, socially and politically that you would have thought would have been relevant. The government changed thrice from NDA to UPA to Congress, the markets went through the tech bubble and bust, outsourcing took off, inflation reached 12%, interest rates fell to 4%, real estate prices rocketed, Lehman collapsed, Saddam died, 9/11 happened, Iraq and Afghanistan got invaded, the price of oil reached ~$160 per barrel, Sensex reached 21,200 from 3,000 and crashed to 7,700, then there was Godhra, Kargil war, terror attacks on Parliament and Mumbai and so on and on. An investor would have had to be exceptionally stable to be able to live through those moments and still believe that his Rs. 100 would ultimately become Rs. 325. That’s a lot to ask from the common man.

On the other hand, all a brainless investor had to do was keep checking to see whether Rs. 10,000 was being debited from his account on the 1st of every month. She would know that whatever the situation may be she would be indifferent because she would be buying the asset at low as well as high prices. The investor would have bought at the bottom of the tech boom and at the height of the 2008 bubble but in the end would have been just 25% worse off than a non-existent Dravid of the investing world. At the same time she would have ended up saving a sizeable amount over the years.

Now let’s look at how we can execute this investment technique. In order to invest in the index every month, we will have to start an SIP on an index fund. Index funds buy stocks in the same weightages as in the index. Since it’s a passive investment technique, these funds have the lowest commissions in the mutual fund industry. There are only 2 things an investor needs to be careful about while choosing an index fund:

1. The Tracking Error or how closely the fund mirrors the benchmark index, and
2. The Fee or what % of the assets managed goes in administrative costs.

The 22-Jan Outlook Money magazine has a detailed list of index funds and their respective tracking errors and fees. I have listed the results below:

Before I end, lets look back at the advantages of an SIP again – 1: It is simple – all it requires is for you to give a standing instruction to your bank, 2: Its strips out the emotional aspect of investing as I have pointed out above, 3: It makes you save a fixed amount every month – Rs 10,000 per month becomes Rs. 12,00,000 at the end of 10 years and 4: Its cheap – the average cost of investing is only 1.3% per annum.

Starting 1st Mar, I will be investing a fixed sum every month in an index fund for hopefully a long period. Investing, after all is all about analysis and patience.



I had briefly mentioned this in my first blog. If an investor wants to invest upfront and ensure safety of principal she could invest in the post office monthly income scheme and divert the monthly interest into an Index Fund SIP. Rs. 4,50,000 invested in post office MIS would yield a monthly income of Rs. 3,000 which could then be invested in an SIP.

Read the PDF of this entire blog by clicking here