Last week, we spoke of lump sum investing versus SIP investing. We discussed why you need to hold your investments for longer periods to avoid the risk of negative returns, if you decide to go the lump sum way.
Just as your ‘time in the market’ (how long you stay in the market) becomes critical when it comes to the question of investing regularly, or at one go, your ‘time in the market’ is also important when it comes to your choice of funds (category allocation), as well as asset allocation.
Risk and time
For instance, every once in a while, a few of you ask us why you should not simply hold a mid-cap fund, or take higher exposure to mid-cap funds as they deliver higher returns, anyway, over the long term. You also substantiate it by saying that investing through SIPs and also holding for the long term anyway reduces risk.
We largely agree with that view. The point of disagreement, if any, is only on what you think is long term, and what it should ideally be to make your perception a reality.
Just look at the example below. We have one diversified fund and one mid-cap fund each from two fund houses – UTI Mutual Fund and Franklin Templeton Mutual Fund (taken for illustrative purposes only). All of these are known to be good, steady funds in their respective category. Let us suppose your ‘long term’ was a 5-year period, and that too it started at the beginning of a good market like early 2006 – the beginning of a 2-year rally.
As can be seen, the two diversified funds delivered superior returns to their mid-cap peers, despite a decent holding period of 5 years and averaging rupee cost throughout. So, what happened?
Two things: you got good returns overall because you had a good down market in 2008 to buy on lows. However, as is the case with mid-caps, they fell hard in a downturn. Also, after every big hit in the market, when a revival happens, mid-caps take longer to bounce back as the bruised market players prefer the ‘quality’ and ‘visibility’ of large cap companies, especially given that they too would be attractively valued post a fall.
So, while you had good portfolio returns overall, you would have had better returns by holding a higher proportion of diversified equity funds than mid-cap funds.
Now, what if you had simply continued the above SIP from January 2006 till date (as of August 14, 2015)? The data below clearly tells you that the mid-cap funds from both houses delivered higher than the diversified funds. But over what period was that? Close to 10 years! And that too if the intermediate falls did not spook you into exiting these funds.
Please note a few things here: I have specifically chosen the 2006-10 time frame (in hindsight) to give you an illustration of years that had both a bull and bear market. Chances are that you may not go through such cycles at all, and that, of course, poses a set of different challenges. But the points I am trying to make here are as follows:
1. Despite a seemingly long term (5 years) holding and investing period, and despite regular investing discipline (SIPs), your portfolio is not entirely insulated from market vagaries.
2. While you do safeguard your portfolio from negative implications through SIPs, there could still be less than optimal wealth building (lower returns), caused by market vagaries (ups and downs).
3. If your theory of staying with higher risk funds such as mid-caps for higher returns is to come true, it is important for you to really stay in the market over the long term.
This is true of asset allocation as well. Some of you feel you do not need debt funds because equity delivers in the long term anyway. While that hypothesis is true, time plays a crucial role here. For instance, a portfolio that had a debt fund with an allocation of at least 20-30 per cent in debt would have fared better than a portfolio with no debt – had you invested lump sum between 2008-13, without knowing what market turbulence can do. Of course, in this case, SIPs would have made your portfolio look better, and having debt would have added further strength. Again, you happened to be in a particularly difficult block of 5 years.
So, am I saying equity investing in only for decadal holding? No. The take away is simply this:
- Average across markets, as far as possible, through SIPs if you have a holding period of around 5 years or less than 10.
- It is not enough to average; it is important to diversify across asset classes to hedge for any lengthy bad years in a certain asset class. The diversification can be based on your time frame and risk-taking ability. Your advisor will help you identify the optimal allocation.
- It is not enough to diversify across asset classes; it is important to hold optimally across categories as well. Too many mid-caps may not always deliver higher returns (20-30 per cent of your total equity portfolio can at most be in mid-caps). Also, it may pull down returns if you are in not the best of market times.
Use SIPs, hold across asset classes, and optimally hold across categories if you wish to build wealth optimally.
However, if you think equities are the only way, risky mid-cap funds are the best means to gain, and staying invested for long is not an issue, then you can be right if you hold for at least a decade, or over multi-decades. The wealth you build will certainly be worth the risks only then.
Your staying power is all that matters, really.
FundsIndia’s Research team has, to the best of its ability, taken into account various factors – both quantitative measures and qualitative assessments, in an unbiased manner, while choosing the fund(s) mentioned above. However, they carry unknown risks and uncertainties linked to broad markets, as well as analysts’ expectations about future events. They should not, therefore, be the sole basis of investment decisions. To know how to read our weekly fund reviews, please click here.