Let's begin with the classic stock-market question: when is the right time to invest in the market? The answer is simple: when it is at the bottom. But where does the 'bottom' lie? Now the answer to this is much harder to come by.
Many would like to invest in a market which is at rock bottom so that their gains may be maximised, but unfortunately nobody knows where the bottom is. Likewise, everyone would like to get out of a market at its peak, that is just before its fall begins. But again, no one knows where the peak is.
There are many in the financial world who claim that they can tell you where the top and the bottom of the market lies by using abstruse calculations, graphs and experience. Don't trust them. There is no one who can consistently predict market moves. Because there are so many 'experts' predicting market tops and bottoms, by sheer probability, someone will be right. But you will never know who that 'someone' is at a given point in time.
So how do you invest so that you can lap up a stock or the units of a fund at a low price. Unfortunately, there is no foolproof way to do that. But systematic investment plans (SIPs) can help. When you invest through SIPs, you automatically experience the benefit of rupee cost averaging. Rupee cost averaging means that as you invest in a particular fund periodically (mostly monthly), you accumulate units at various prices (called net asset value or NAV). You get more units when the market is down and the fund's NAV is lower, and you get fewer units when the market is up and the NAV is higher. Over time, as your SIP progresses, you will have invested across all market phases. So your average cost will be reasonable.
Let's look at an example. Suppose you invest Rs 10,000 in a fund at the following NAVs: Rs 200, 250, 150, 100 and 300. You will accumulate the following number of units: 50, 40, 66.66, 100 and 33.33. Your total invested amount is Rs 50,000. The total units are 289.99. The average NAV works out to Rs 172.41. This amount is less than three of the five NAVs at which you bought the fund.
SIPs do not magically work to lower your investment cost in a guaranteed way. If the markets only went up in a linear fashion, you could invest all your money today to make the most of it. Needless to say, investing does not work this way. By their very nature, markets are volatile. This is why it makes sense to spread your investments over a period of time to benefit from the lows that frequently occur. Of course, this strategy does preclude the possibility of you getting the highest possible returns from investing all your money at a market low. But it is in its ability to keep you from investing all your money at a high that the real value of an SIP lies.
More than a financial tool, SIPs are a psychological tool of discipline. By nature, investors are tempted to invest more when the market is racing and stop investing altogether when it is falling. This hurts returns. SIPs automate the entire investment process and delink sentiment from investing, allowing you to benefit from rupee cost averaging to get a good return.