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Mutual Funds - Being Risk Averse

Risk comes from not knowing what you’re doing – Warren Buffet

Traditionally, we have seen people investing mostly in FDs and other lumpsum conservative instruments. Now a days, we do realize that this is not going to beat inflation in long term and consequently result in effectively lowering the purchasing power than gaining anything out of it.

Most of us would have noticed the rise in awareness campaigns of mutual funds investing. Most prominently, ‘Mutual Funds Sahi hai’ (In English, read – ‘Mutual fund is the right’ way’) ads in various print, TV and online media. What I have noticed is that a lot of us really don’t go about investing in mutual funds ‘the actual right way’.

With traditional mindset of FDs, we think about ‘Invest lumpsum in Mutual funds & forget!’ Well, this would most probably prove to be a costly mistake considering the underlying composition of mutual funds which strongly depends on market cycles. If the lumpsum investment timing is not correct (which is going to be more than 85% of the time), it’s bound to generate loss and you would feel mutual funds are not good!

So, now the question – What is the actual right way of investing in mutual funds? You would have heard about SIP or Systematic Investment Plan. SIP is a systematic option of investing regular amounts over well-defined fixed intervals of time. Below are some inherent properties of SIP and how it helps reducing risk and generating wealth:

1. Currency Cost Averaging:

Since, you are investing the same amount during fixed intervals, the total investment remains the same. During a bull run, you are allocated less units while during a bear run, you are allocated more units. Over a period of time, irrespective of the market cycle, the average cost/unit turns out to be lower than the average cost/unit at market price. Consequently, the NAV is averaged out reducing the risk of different market cycles.

The table below shows a sample hypothetical data on how the accumulation of units works and how the cost is averaged out. This is only for illustration purposes.

Your average cost of units is lower than the market average cost of units.

Considering just this 1-year table and only 12 data points, you can figure out that had you invested in lumpsum on any other month than the four colored in amber – you would have ended up buying the units costly than in SIP mode. This is just a hypothetical set of data. In reality, few periods of time may look favorable for lumpsum (in bull cycle). But, if you consider long term investment, SIP wins more than 85% of the time.

2. Flexibility: 

You have the freedom to exit or redeem units whenever you want and whether you have completed the tenure of not.

3. Maintaining discipline:

It inculcates a discipline in investing a fixed amount at regular intervals over a period of time. It shields you from human emotions of market cycles tempting you to take an injudicious action.

4. Compounding Power:

If investment is continued for long term ( >5-10 Yrs), the corpus accumulated at the end of tenure tends to beat most of other investment instruments.

Conclusion: SIPs ultimately, help you stagger your money across different market cycles which consequently makes it a tad easier riding the volatility. 

P.S – Above explanation is focused on equity or equity-oriented mutual funds. When it comes to Debt mutual funds (esp Ultra Short Term), I personally prefer both lumpsum and SIP considering it rarely goes into bear phase. Please consult your financial advisor before taking any decisions if you are not aware of what you are doing.

As always, Thanks for Reading!

Personal Finance

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