Three risks to avoid in Mutual Fund SIPs

Risks in Mutual Funds SIPs, you were not aware of

So, we are now convinced that the SIP is the best way to create wealth in the long term. Remember, the SIP is not a strategy, but just a more systematic method of investing in a fund. It serves two purposes. Firstly, it syncs SIP outflows with your regular inflows. Secondly, by averaging your buying cost over time, the SIP reduces the cost of acquisition and thus enhances the yield on the investment. That is the return side of the story. Have you wondered, what is the biggest risk when it comes to SIPs. It is the “risk of not taking adequate risk.” That may sound rather paradoxical, but let me explain. When doing SIPs, you cannot do SIPs at random. SIPs have a time dimension to it, asset mix dimension to it and also a dimension of allocation risk to it.

When you invest; be it in lumpsum or via SIPs, there is an opportunity cost to it. You are forsaking all other opportunities to put your money in a SIP. Hence, it behoves upon you as an investor to ensure that you evaluate the various alternatives and logically conclude that the SIP is the best option. In short, you need to make SIPs work and for that to happen, you must manage the 3 critical risks viz., the time risk, asset risk and the allocation risk.

Know more about sip calculator

Time Risk – not starting the SIP early enough

This is one of the biggest opportunity losses in SIP investing. The SIP thrives on the concept of compounding wealth and that normally works best over the long run. Compounding over 30 years has a natural advantage over compounding for just 5 years. That is because; the earlier you start, the longer you stay invested. What does that really mean? Over a longer period of time, not only does your principal compound more but even your returns compound more. It is only after the sixth or seventh year that the interest on interesting becomes more dominant than interest on principal. The earlier you start and the longer you stay invested, the more time works in your favour. After all, when it comes to SIPs, it is time in the market and not timing the market that really makes the big difference.

However, it would be best to illustrate this difference with a live illustration. For example, assume two investors A and B. While A thinks long term, B feels there is no hurry to start saving and investing. As well spend to your heart’s content today and worry about saving and investment at a later stage. Obviously, in this case, the power of compounding will work more effectively in the case of A than in the case of B. To pinpoint the issue better, let us assume that Investor A starts the SIP at the age of 25 and continues all the way to 60, while Investor B starts only at the age of 45 and continues till 60. How do A & B compare? To make this illustration more credible, let us also assume that to make up for the lost time, Investor B zeroes on a SIP amount that is 4 times the size of the SIP that investor A runs. 

You would actually wonder; how can Investor B end up poorer after his SIP was 4 times the size of the SIP of Investor A. What is more, during the tenure of the SIP, A investors just Rs21 lakhs of his own money while B invests Rs36 lakhs of his own money. Despite that, at the age of 60, Investor A ends up with a corpus of Rs5.62 crore while Investor B ends up with a corpus of just Rs1.23 crore. In other words, the wealth ratio (ratio of accumulated wealth to actual investment) is 26.8 times for A while it is just 3.4 times for B. That just goes to show what an acute impact starting early has had on wealth creation. It is not enough to invest more at a large stage. Instead, even investing small amounts in SIP at a younger age for a longer period can substantially magnify returns.

Asset Risk – not having adequate equity exposure

We saw the impact of starting SIPs early. Starting late is a major risk, but an equally important risk is being invested in the wrong asset. If you are in the wrong asset class, you will not generate enough wealth, irrespective of how long you hold the asset. For 25 year SIPs, your logical preference should be equity funds and not debt or liquid funds. Check out the comparison of Investor C and Investor D below.

Here Investor C and Investor D are contributing the same amount over 35 years and both start early. However, C puts the money in equity funds while D puts the money in income funds. In other words, Investor D runs the risk of not taking on enough risk. The results are obvious.

Rebalancing Risk – not moving portfolio with market shifts

What rebalancing risk mean? One of the core ideas of asset allocation is to ensure that you automatically keep churning profits when the asset class becomes overheated. If your original allocation to equities is 50% and due to a bull run it has gone up to 65%, then it is time for a course correction and reallocation back to targeted levels. That way you stay invested in rising markets and have liquidity when markets are down. You don’t need to tweak your portfolio too frequently, but an annual review and rebalancing once in three years is surely called for.