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Casino SIP

SIP returns are always superior to lump-sum investments any time there are positive returns. When NAV falls, increasing SIP improves returns.

Experienced gamblers manage bets carefully. While the odds in most casino games favour the house, a clever gambler can improve chances by handling stakes right. In European roulette, there are 18 numbered black slots, 18 numbered red slots and a zero. The house wins every time the ball enters zero. A bet on either colour offers even money while the odds on winning a given colour bet is 18:19 against. Martingale and D'Alembert betting systems use increments to try and improve the odds. Both systems increase stakes after each loss. The hope is that wins (although a little fewer in number) will generate enough to balance off more frequent losses.

A Martingale System doubles stakes after every losing bet. This is impractical both in a casino with an upper limit and in the stock market. The D'Alembert System adds a smaller, pre-set increment after each losing bet.

A Paroli System tries the opposite strategy - it increases stakes following a win and lowers stakes after a loss. Implicitly, a Paroli System hopes for “runs” - that is, a trend of successive wins at successively higher stakes.

There are some interesting parallels between betting systems and standard methods of systematic investing. There are also obvious differences.

The biggest difference: Every spin of an unbiased roulette wheel is an independent event. It is uninfluenced by previous spins. However, the stock market offers trends; even in a perfect market with random price fluctuations, prices are benchmarked to previous price - so inter-dependence exists. So, successive gains (or losses) are more likely in the stock market.

A SIP averages down. SIP returns are always superior to lump-sum investments any time there are positive returns at all. Suppose you use a D'Alembert-System to weight a SIP. That is, every time NAV drops, you increase the SIP. That should improve returns.

A casino SIP is not difficult to implement. Here are the rules:
Every month, compare prevailing NAV to the NAV of the previous SIP.
If the NAV is the same or higher, invest the same amount as last month
If the NAV is lower, do a 20 per cent D'Alembert - invest 20 per cent more.

I would do this only with a highly-rated fund which has a long-term track record. That way I am confident that falls are temporary and my long-term return will be positive.

Doing test runs with the NAVs of 8 mutual funds from June 2002 onwards, one discovers that the differential is positive in all cases for D'Alembert-style SIPs. During this five-year period, there were 44 months with positive month-on-month NAV growth versus 15 months with negative month-on-month returns.

But the differences are very small- hardly enough to be worth the trouble. Even with a doubling Martingale-type SIP, where one doubles SIP everytime NAV drops, large excess returns aren't available. Maybe a casino-style SIP offers larger rewards if the time-period includes a long bearish phase but we don't have data to test this hypothesis.

However, even though it doesn't gain a lot, casino-style SIPs may still be useful from a behavioural standpoint. Most investors have a psychological barrier to increasing exposure in losing situations. Both commonsense and the results generated here suggest that this is a good strategy and a casino-style SIP may encourage this.

Now, look at Paroli-type methods. Paroli involves averaging up or pyramiding. It is a standard trader's technique - good traders often add to winning positions. The average cost rises but if a trend is running in favour, you are betting on a "sure thing". Pyramiding is less common with investors. But even Warren Buffett has been known to increase his stake in a company even after the share price has risen. Across our test population and time-frame, a Paroli-style SIP gives marginally lower returns than a normal SIP. But it does commit more resources to the stock market during an extended bull run. The utility of Paroli Systems could lie in that its helps fine-tune asset allocation. A big bull run is a situation when investors should be more fully-invested. A Paroli encourages the movement of cash from lower-yield assets into equity in such situations. Of course, it may also tempt somebody to time the market!