How long should that SIP be?

Summary: When investors receive a large lump sum, deciding how long to stagger it through an SIP becomes an important question. This article explores the trade-off between reducing market-timing risk and staying invested long enough to benefit from equities.

It's a question that vexes many mutual fund investors once they buy into the concept of investing through a systematic investment plan (SIP): When you have a lump sum to invest, then over what period should you spread the SIP?

Of course, for most SIP investments, the question does not arise. The most common type of SIP investment is a monthly one that goes out of a monthly income. This sort of SIP continues perpetually and is simply a way to keep investing without bothering to actually take the time out and do it.

Suggested read: Why SIPs score over lump sum investments

However, occasionally, the SIP investor gets a large sum of money at one go. It could be a bonus from a workplace (although that's a rarity nowadays), or it could be the proceeds from the sale of some asset like real estate, or it could even be your retirement kitty, which you need to spread and make it last for the rest of your life.

As every saver should know, investing in an equity-backed mutual fund is one of the most effective ways to generate strong returns over a long period such as five to seven years or more. However, over shorter periods, equity funds can be risky. And when you invest a large sum in one shot, that risk becomes even more pronounced. If the markets turn sharply downward, you could lose 10, 20 or even more per cent of your invested amount very quickly.

Since the beginning of the Sensex in April 1979, there have been nearly 13,900 possible six-month periods. Out of these, as many as 2,269 produced a loss worse than 20 per cent. If you happened to invest a large amount right at the start of such a period, you could see a significant chunk of your capital erode before it even begins to grow. In theory, the market might eventually recover. In practice, however, many investors panic and withdraw their money, turning a temporary decline into a permanent loss.

The antidote to this problem is a systematic investment plan. By spreading your investment into monthly instalments over a defined period, your entry price gets averaged out. This reduces the risk of investing everything just before a sharp decline. It also allows you to buy more units when markets fall and fewer when they rise, which is the fundamental advantage of SIP investing.

That much is widely understood. The tricky part is deciding what that ‘defined period’ should be. Should the SIP last six months, one year, two years or even longer?

Some time ago, Value Research conducted a study on historical SIP returns and found that SIP investments became remarkably stable after about four years. On average, when investments continued for four years or more, the probability of suffering a loss became extremely small.

Interestingly, both the risk of loss and the possibility of extraordinary gains are higher over shorter periods. Over longer periods, the highs and lows tend to average out, and the range between best and worst outcomes narrows considerably.

Consider this example from funds with multi-decade histories. Across all possible one-year periods, the maximum annualised return observed was about 160 per cent, while the worst was –57 per cent. Over two-year periods, the range narrowed to roughly 82 per cent and –34 per cent. Over three years, it became about 63 per cent and –18 per cent. By five years, the range tightened significantly to around 54 per cent on the upside and roughly 4 per cent on the downside—meaning losses essentially disappeared over those longer windows. Over ten years, the range was even narrower, between about 30 per cent and 13 per cent annualised.

The trade-off is clear: shorter periods offer the possibility of higher gains but also carry much greater risk.

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From this data, a straightforward conclusion might be that SIPs should ideally run for more than three years. If the objective is to virtually eliminate the possibility of loss, that is indeed a sensible answer.

However, in many real-life situations, such a long period may not be practical. Suppose you receive a yearly bonus from your employer. Spreading that amount over three or four years would hardly make sense because the next bonus might arrive before the previous one has even finished investing.

On the other hand, imagine selling ancestral property where the proceeds are meant to support your financial security in old age. In such cases, protecting the capital becomes far more important. It may make sense to sacrifice some potential gains in exchange for reducing the risk of a large early loss.

One elegant rule of thumb is to spread the investment over roughly half the period it took to earn the money, subject to a maximum of about four to five years. By this logic, an annual bonus could be invested over six months, while money accumulated over decades, such as proceeds from ancestral property, could reasonably be staggered over several years.

It’s essentially a way of aligning the investment risk with the significance of that money in your life.

Also read: The SIP advantage