We have all heard that it’s important to have a long-time horizon when investing in equity markets via systematic investment plans (SIPs). But have you ever wondered how long is ideally ‘long term’ when it comes to investing in Equity via SIPs?
Let’s put different timeframes to test…
Let us evaluate SIP returns of Nifty 50 TRI over different timeframes. For this, we have considered different SIP journeys starting at the beginning of each and every month from July 99.
So, the series would look for SIP journeys beginning on July 1, 1999; August 1, 1999; September1, 1999; and so on up till now.
Over a 1-year timeframe, there were 66 occurrences (out of 262 occurrences) where the SIP portfolio ended up making negative returns. In other words, 25 per cent of the time, which is one out of four times, the equity SIP made negative returns over a 1-year timeframe.
Verdict: 1-year is too short a timeframe and definitely not suitable for equity SIP investing.
When we extended the timeframe to three years, the occurrences of negative returns reduced from 25 per cent to 11 per cent. While this was definitely an improvement over the 1-year timeframe, negative returns for 11 per cent of the times was still a concern.
Verdict: 3-year timeframe is also not suitable for equity SIP investing.
Let us now extend the timeframe to five years. Unlike 1- and 3-year timeframes, the number of negative occurrences drastically dropped. Out of a total 214 occurrences, there was only one occurrence where the returns were negative!
Thus, by extending the timeframe to 5 years we,
Lower the chances of negative returns – only 0.5 per cent of the times the portfolio gave negative returns compared to 3- and 1-year timeframes.
Improve our chances of better returns – eight out of 10 times the portfolio earned returns of more than 10 per cent
However, there was still a 10 per cent chance that you could end up with mediocre positive returns (0-7 per cent)
Verdict: Five-year timeframe works reasonably well most of the time. But there is still a 10 per cent chance of mediocre returns
Let us extend the timeframe further to see what the returns looked like over a 7-year timeframe.
There was zero occurrence of a negative return
Lower occurrence of mediocre returns – only 3 per cent of the times the portfolio earned lower than 7 per cent returns
Improved chances of better returns – 78 per cent of the times the portfolio earned greater than 10 per cent returns
And the winner is…
Investors who invest in equity SIPs should ideally choose a timeframe of at least seven years, as this helps in increasing the odds of reasonable returns, while reducing the odds of mediocre and/or negative returns.
But why do the returns improve with time?
The reasons are:
Market declines of 10-20 per cent happen every year: Equity markets witness 10-20 per cent temporary declines almost every year. We looked at year-wise drawdown for Sensex from the period starting 1980, and in 40 out of the 43 years, the intra-year declines were 10-20 per cent.
Large market declines of 30-60 per cent happens once every 7-10 years: Historically, large market declines of 30-60 per cent have occurred once every 7-10 years, and subsequent recoveries have usually taken around 1-3 years.
SIP investors benefit from market falls and recoveries, as they accumulate more units at lower prices, and when the market recovers, the extra units accumulated also participate in the upside, thereby, enhancing overall returns.
So the key here is that the SIP timeframe should be reasonably long enough to accommodate both the market fall and the recovery time. While the 10-20 per cent falls are common and markets recover quickly, the larger falls (>30 per cent) take around 1-3 years to recover. This is why a longer timeframe of seven years is helpful, as it provides a sufficient buffer time to accommodate for occasional large falls and recovery in the middle of your SIP journey.
But what if there is a sharp decline at the end of a 7-year period?
In the earlier section we found out that if large falls happen during the first few years of your equity SIP journey, then a 7-year timeframe provides enough time to recover. However if such large falls happen close to the end of your 7-year timeframe (say in the sixth or the seventh year), then your 7-year SIP returns will also most likely be impacted.
So, how do we solve for this?
The way to do so is by simply extending the timeframe by 1-2 years more.
Let us see if this suggestion works well in reality.
We isolated for all 7-year SIP returns where the returns were less than 10 per cent. We found there were 42 occurrences out of a total 190 such occurrences.
As seen from the SIP matrix below, in 31 occurrences out of 42, extending the timeframe by just 1 year brought the returns back to more than 10 per cent. In the remaining 11 occurrences out of 42, extending the timeframe by just two years brought the returns back to more than 10 per cent.
Summing It Up
When it comes to your equity SIPs, invest with a timeframe of at least seven years. Historically a 7-plus year timeframe helps you to minimise your odds of negative returns (no occurrences in the last 22-plus years), and also increases your odds of better returns (>10 per cent CAGR).
In addition, longer timeframes allow enough time for recovery from large market falls. During periods of intermittent market declines, equity SIP investors benefit by accumulating more units at lower prices, and subsequently, when markets recover (usually in 1-3 years) you improve your chances to earn better returns, as higher units accumulated at lower prices participate in the upside.
If markets experience sharp temporary declines near the end of your 7-year time horizon, then you may need to extend your timeframe by 1-2 years to allow for market recovery and reasonable returns.
The author is senior research analyst at FundsIndia
(Disclaimer: Views expressed are the author’s own, and Outlook Money does not necessarily subscribe to them. Outlook Money shall not be responsible for any damage caused to any person/organisation directly or indirectly.)