In the previous post we talked about systematic investment plans and how they are a tool for rupee cost averaging. One type of systematic investment is the systematic transfer plan or STP.
STP’s are an effective way to transfer money from one fund to another in a regular manner. The most common use I have seen for STPs by investors is as a market timing tool.
For example, consider a scenario where equities have rallied strongly, and fundamentals indicate that stocks are overvalued. I have seen investors who do not want to risk putting all funds as a lump sum investment because they feel the market will correct in the near term. They therefore put the money in a debt fund or liquid fund and then use an STP to regularly buy into the market. The logic goes that if the market corrects then they will be able to bring the average cost of units down by regularly buying at lower and lower prices.
However, there is a downside to this. We have established before that being able to time the market is extremely difficult and so it could just as easily be the case that the market goes up. If that happens, then the average cost of units will go up compared to buying in lump sum.
In this use case, the STP could work either for or against you depending on how the market turns out – which is more down to luck.
However, there is a use case where STPs can be more useful – and that is for the achievement of your financial goals. When you have a financial goal, you will have a portfolio with a certain risk-return profile and a time within which to meet your goal.
As you get closer and closer to your goal, it is important that you reduce the risk and volatility of your portfolio so that you have more certainty about achieving your goal. The idea being that you don’t want a sudden market movement to dramatically reduce the value of your investments when you are close to the target date of your financial goal because there might not be enough time for those assets to recover, hampering your ability to meet your goal. This is where STPs become extremely important.
An investor can use the STP to regularly exit the riskier part of the portfolio and put the proceeds in safer fixed income instruments. This reduces the risk of market timing and of volatility in the portfolio as you get closer to your goal.
Rather than being reliant on value of the market at any one particular time, the investor captures the average value over a longer period. And, with a higher and higher portion of investments moving to lower risk investments as you get closer to your goal, it means that the portfolio will stay within a much narrower range. This gives a lot more clarity about the final amount that can be realized for your financial goal.