Once upon a time there lived a poor woodcutter. On a hot, sultry day he was chopping down a large tree near a river. As he toiled hard at work, his axe accidentally fell into the deep river.
Realizing what had just happened, the woodcutter broke into tears and was inconsolable.
Seeing his sorrow, a fairy appeared in front of him and comforted him. Out of her immense kindness, the fairy set up a small wood shop for the woodcutter’s livelihood and advised him to invest his monthly savings into equity markets.
Before vanishing, the fairy pondered for a minute and presented him with four wishes. She said the wishes would allow him to go back in time and change one thing about his portfolio, if needed.
The grateful woodcutter profusely thanked the fairy and began work at his new shop with utmost sincerity.
Months later, as his income levels started rising, he took the fairy’s advice and started a monthly SIP in Nifty 50 TRI.
While his portfolio did really well, the woodcutter was pained to see the drops in his portfolio caused by the intermittent declines in the equity markets.
In order to avoid such declines, he decided to use one of the four wishes.
Wish 1: I wish the Equity market had grown in a straight line with no volatility…
The woodcutter’s wish came true and as a result, the Nifty 50 TRI grew as a straight line exclusively for him.
He became extremely happy and checked his portfolio returns to see how well he had done.
However, the results gave him the shock of his life!
The SIP in Nifty 50 TRI that grew linearly delivered a CAGR of just 9.3% in the last 22+ years!
Feeling let down, the woodcutter decided to use his second wish.
Wish 2: I wish the Equity market had grown at a constant rate…
This time the woodcutter wished for an index that compounded on a consistent basis without any volatility i.e. index delivering equal returns every year.
After the wish was granted, he immediately checked his portfolio returns.
With a constant return trajectory, Nifty 50 TRI offered a CAGR of 14.3% since inception!
The woodcutter was quite happy with the performance of his portfolio.
However, the happiness didn’t last long. He noticed that his friends who simply had invested via an SIP in the actual Nifty 50 TRI made even better returns.
And that got him disappointed!
Suddenly, an idea struck him. He firmly believed in its ingenuity and used his third wish.
Wish 3: I wish the Equity market had grown without any major falls…
The woodcutter this time wished for an index that participates in all the market upside but escapes all the major intermittent declines (above 20% declines).
The SIP returns of a Nifty 50 TR index where none of the major declines (declines over 20%) happened were 13.5%!
The woodcutter was taken aback. His returns were even lower than the returns from the previous time – what he thought was an intelligent solution clearly didn’t work as he had hoped for.
All these underwhelming results, humbled him.
He used his final wish.
Final Wish: I wish to invest in the normal Equity market with all its intermittent declines…
This is how the portfolio performed when simply invested in the actual Nifty 50 TRI…
By simply staying the course, and investing every month via an automated SIP into the plain vanilla Nifty 50 TRI, the woodcutter realized a CAGR of 15.2%.
But why does this happen?
Systematic Investment Plan (SIP) as a mode of investment works well when two things come together
- SIP is made in a Growing Asset Class
- The Asset Class is Volatile (i.e has several temporary intermittent declines)
Thankfully Equities satisfy both the conditions, as equity returns over the long run mirror earnings growth of the underlying companies and intermittent declines provide an opportunity for SIP to accumulate more equity mutual fund units.
Summing it up
While it looks extremely counterintuitive, when we try to move in and out of equities to avoid the volatility in returns, more often than not, we actually end up badly damaging our investment returns and experience – just like the woodcutter.
As learnt from our hypothetical woodcutter, whenever we experience temporary falls in the market, instead of wishing for it to go away, the ideal response should be to accept and embrace it.
The simple idea is that – periods of intermittent declines is where the long term performance actually gets enhanced for an SIP investor.
So if you are an SIP investor, as weird as it sounds, you should in fact be praying for a lot more intermittent declines instead of a smooth journey!