Systematic Investment Plans (SIPs) have become a household name in the world of personal finance. It is sold by Mutual Fund houses to Finfluencers as a fix all for market volatility.
But why exactly has this investment strategy gained such widespread fame? Here are a few key reasons:
Discipline & Automation: SIPs are all about fostering discipline in your investment journey. By setting up a fixed amount to be automatically invested at regular intervals (weekly, monthly, quarterly), you remove the temptation to time the market and ensure consistent participation in the growth story.
Affordability & Accessibility: SIPs cater to all income brackets. You can start with a small amount, as low as a few hundred rupees, making it a truly accessible investment option for everyone. This allows individuals to build wealth gradually, one SIP at a time.
Power of Compounding: SIPs leverage the magic of compounding. By investing regularly, you benefit from reinvesting your returns, allowing your money to grow exponentially over the long term. This compounding effect is a significant driver of wealth creation in SIPs.
Reduced Risk & Rupee-Cost Averaging: SIPs help average out the cost of your investments. By purchasing units at different price points throughout the market cycle (highs and lows), you reduce the overall investment cost and mitigate the risk associated with volatile markets.
However the same Rupee cost averaging can work against you when its time to withdraw money from your SIPs using Systematic Withdrawal Plans.
Systematic Withdrawal Plans (SWPs) are a popular investment strategy for generating income from your investments. You periodically withdraw a fixed amount from your investment, providing a steady stream of income during retirement or other financial goals.
But here's the catch: the market doesn't always cooperate. There's a hidden villain lurking within SWPs – sequence of return risk. This risk refers to the impact of the order in which you experience returns on your investment during the SWP period.
Understanding Sequence of Return Risk
Imagine you're setting up an SWP from your investment portfolio. Ideally, you'd like consistent, positive returns throughout the withdrawal period. However, the reality of the market is that there will be ups and downs.
Early Market Downturn: If you experience a significant decline in your investment value early in your SWP, it can deplete your principal faster than anticipated. This can leave you with less money to grow over time and potentially force you to lower your withdrawal amount to sustain your income stream.
Market Volatility: Even if there's no initial downturn, high volatility can disrupt your SWP. Periods of low returns can strain your withdrawals, while periods of high returns might tempt you to increase withdrawals beyond a sustainable level.
Combating the Sequence of Return Risk Villain
While sequence of return risk can't be entirely eliminated, there are strategies to mitigate its impact:
Diversification: Spread your investments across different asset classes (stocks, bonds, real estate, etc.) to reduce your overall portfolio's risk. A diversified portfolio is less susceptible to the swings of a single asset class.
Flexible Withdrawal Strategy: Consider a more flexible withdrawal approach. Instead of a fixed amount, you could base your withdrawals on a percentage of your portfolio value. This allows you to withdraw less during downturns and potentially more during upswings, helping to preserve your principal.
Start SWPs Later: If possible, delay the start of your SWPs. The longer your investment horizon, the more time your portfolio has to recover from any market downturns.
Monitor and Rebalance: Regularly review your portfolio and rebalance as needed to maintain your desired asset allocation. This ensures your portfolio stays on track with your risk tolerance and investment goals.
Example time
Let's imagine Mr. Patel, a resident of Bengaluru, India, is planning for his retirement. He has a well-diversified portfolio of Indian mutual funds and decides to set up a Systematic Withdrawal Plan (SWP) to generate a monthly income stream.
Scenario 1: The Favorable Sequence (Unlikely Hero)
Year 1-3: The Indian stock market experiences a strong bull run. Mr. Patel's portfolio enjoys significant growth, allowing him to withdraw his planned monthly amount (say, Rs. 50,000) comfortably.
Year 4-Retirement: The market continues a healthy upward trend. Mr. Patel can potentially even increase his withdrawal amount due to the growth in his portfolio value. This scenario showcases a favorable sequence of return, where positive market performance throughout the SWP period allows for a sustainable income stream.
Scenario 2: The Unfavorable Sequence (Sequence of Return Villain)
Year 1-3: The Indian stock market experiences a significant decline. Mr. Patel's portfolio value drops considerably. To maintain his desired monthly income (Rs. 50,000), he's forced to withdraw a larger percentage of his remaining investment, effectively selling at a loss.
Year 4-Retirement: Even if the market recovers later, Mr. Patel's portfolio might have a smaller base due to the early withdrawals during the downturn. This can limit his ability to withdraw the same amount throughout his retirement or force him to reduce his withdrawals, potentially impacting his lifestyle.
Hence its important to remember that SIP might give you supposed Rupee cost averaging which might in a correcting market. But the same can occur when you withdraw amounts during your time of need which could be retirement or other goals. Hence it is important to manage your portfolio allocation by age and how close you are to withdrawal.
Comments