Why SIPs score over lump sum investments

Systematic Investment Plans (SIPs) are not magic. Their superiority to lump sum investments is a matter of probability or even psychology and not an absolute law. This means that most of the time, under most circumstances, over a sufficiently long period, SIPs will do better.

To understand this, you just have to review what an SIP is and what it does. An SIP is an investment in a fund of a fixed amount at pre-defined intervals, generally monthly. SIPs neatly solve the two main problems that prevent investors from getting the best possible returns from mutual funds. These are:

• People try and time the market to buy at the bottom and sell at peaks
• People invest at irregular intervals and then stop investing when markets fall

Considering the first problem, since SIPs mean regularly investing with a fixed sum regardless of the NAV or market level, investors automatically buy more units when the markets are low. This results in a lower average price, which translates to higher returns. If you invest a large sum in one go, you could end up catching a high point in the equity markets. This would mean that you would invest at a high NAV and reduce your gains if the market falls. An SIP is a good way to average your purchase price over a while.

Coming to the second problem, SIPs help people stay invested through the ups and downs of the market. Investors inevitably try to time the market. When the market falls, they sell and stop investing. When it rises, they invest more. This is the opposite of what should be done. An SIP puts an end to all this by automating the process of investing regularly. It eliminates the mental load of deciding when to invest and leads to better returns.

It's clear from the first point above that while a lump sum investment could catch a high point in the market, it could also coincidentally catch a low point. In this case, it would give better returns than an SIP during that period. In a generally ascending market, of the kind we had from 2003 to 2008, SIPs are almost always better for periods over a year or so. In a drifting equity market, this is not always true. However, investors should also see that its ability to tackle the problem of investor psychology gives SIPs much of their value.

This story first appeared in December 2013.