A recent report on a website focused on mutual fund investing suggests that your terminal wealth could be lower if you pause your systematic investment plan (SIP) during volatile markets.
In this article, we discuss why it is optimal to continue your SIP through the time horizon for a life goal. We also discuss why the process is behaviourally more optimal for passive funds than for active funds.
Distancing regret
Market timing is an active decision — you must decide when to invest and when to exit the investment. Such active decisions are required for your trading portfolio, also called the satellite portfolio.
Market timing could be implied while managing SIPs in your goal-based portfolio, also called the core portfolio. Why? The fear of a falling market may compel you to pause your SIPs.
But you must decide when to restart your SIPs, and that is an active decision. What if you pause your SIP and the market moves up or restart your SIP and the market declines further? You could regret your decision to time the market.
The advantage of SIPs is that you can distance yourself from the investment decision after you set up the process. This is because the monthly SIP is set up as an automatic debit to your preferred bank account.
Therefore, the regret associated with an investment decision when the market declines are less when you use SIPs than when you manually invest each month in the same fund.
Market timing must not be part of your investment decision for the core portfolio. Therefore, staying invested through the time horizon for a life goal is an optimal way for accumulating wealth to achieve a life goal.
But that would be appropriate when you set up a SIP on a passive investment such as an index fund or an exchange-traded fund (ETF). The objective of investing in an active fund is to generate alpha returns — the excess returns that a fund generates over its benchmark.
Therefore, a SIP on an active fund must be set up for one year at a time. That way, you will be able to review your investment in the fund and decide whether to renew the SIP, switch to another active fund, or move to a passive fund.
But that would be an active decision. You must, therefore, weigh the likely experience of pain and regret if your active decision were to turn wrong against the potential benefit of earning alpha returns.
(The author offers training programmes for individuals to manage their personal investments)