Investing in financial markets has had a mixed reputation over the years. We often hear success stories of prodigy investors making a killing in the markets. At the other end of the spectrum, there are disgruntled folks who have lost money in the financial markets and don’t want to consider it as a viable investment option ever again. What is common between these two categories of people? They tried to get higher than average returns by trying to time the market. When you try to do that, unless you’re a fortune teller, you either lose big and if you’re lucky, you win big.
However, what about the investor who just kept putting aside money in a basket of funds and kept getting average sustainable returns over the years? He beat inflation comfortably and grew his money consistently over the years. But this is boring, so no one talks about it. It’s a pity because this is a much better strategy to assure returns over the long term.
Let us understand how the financial markets work before we go into how we can use this strategy to our advantage.
What are financial markets and what moves them?
Financial markets refers to a marketplace to buy and sell instruments such as stocks and bonds. The prices at which these instruments are bought and sold are determined by two main factors:
- Productivity growth: Over time, as economies grow, the total amount of productivity in the economy grows. Companies, which are the most basic units in an economy, also grow over time with higher productivity and profitability. This in turn leads to a rise in company value as well as their stock price. If markets relied purely on this factor, there would be a steady growth in the overall value of the stock market.
- Impact of human emotions – In a financial market, this refers to investor sentiment which is characterised by volatility. If there is good news about a certain company, its stock price shoots up and vice versa. This results in the high amount of fluctuations we see in the markets. Over the short term, the impact of this can be significant. However, over time, the abnormal positive and negative fluctuations cancel each other out to result in a normalised outcome.
As long as the overall productivity in the economy rises, with innovation as fuel, the markets will rise. The growth of productivity has been a constant ever since the very existence of the financial markets. Human behaviour causes short term variations in the prices but over a long period of time, it averages out and the overall value of the market increases. The curve below highlights the impact of both the factors in the movement of the markets.
Hence, our aim when investing is to eliminate the short term fluctuations and tag onto the productivity growth line. That is the hack to investing. It is ridiculously easy to do this – Systematic Investment Plan (SIP).
Hack to investing - Systematic Investment Plan (SIP)
An SIP is a plan where the investor invests a fixed amount at regular intervals into a portfolio of Mutual Funds or Exchange Traded Funds. This process helps us average out the buying price for the funds within the portfolio. Essentially, we end up cancelling out the short-term fluctuations and buying units at the “productivity growth” line (see blue line above) over the long term. This process is called dollar cost averaging. A few points to keep in mind while executing an SIP:
- Selecting good SIP schemes: Good SIP schemes have a few characteristics. They are fairly priced and not high cost. They give you flexibility to make changes over time and withdraw your funds as and when needed. The underlying fund portfolio is made of quality Mutual Funds or Exchange Traded Funds.
- Keep your emotions at bay: While executing an SIP strategy, there may be times you might get carried away and try to time the market. Keeping these instincts at bay are paramount for success in this approach. In times of market turmoil, you might be tempted to withdraw your investment to cut losses. However, this might be the worst time to surrender your investments and will almost certainly lead to losses. Keep calm and carry on.
- Increasing your SIP amount yearly: As the years go by, your income grows and your goals evolve. Your SIP needs to keep up with these changes in your life. Annual revisions to your SIP amounts are a good practice to make sure of this.
There are a lot of “get rich” schemes in the market that promise unrealistic returns and prey on the human need for instant gratification. However, most of these schemes actually end up making higher losses over time. Patience and perseverance are what are needed to be successful while investing over the long term. Cut out the short term noise and focus on where the growth is in the long run.