Why SIPs score over lump sum investments?

Here's how SIPs solve the two main problems that usually prevent investors from earning good returns from equity funds

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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. What this means is that, most of the time, under most circumstances, over a sufficiently long period of time, SIPs will do better.

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To understand this, one just has to review what a SIP is and what it does. SIP is a regular investment in a fund of a fixed amount at a fixed frequency, generally monthly. SIPs neatly solve the two main problems that prevent investors from getting the best possible returns from mutual funds.

Firstly, since SIPs mean investing with a fixed sum regularly 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 at one go, you could end up catching a high point of the equity markets. This would mean that you have invested at a high NAV and that would reduce your gains if the market falls. An SIP is a good way to invest at an average price over a period.

Secondly, SIPs are also a great psychological help while investing. 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. This would make it superior to SIPs. In a generally ascending market, of the kind from 2003 to 2008 or the kind we have for the past one year, 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 the second point above, about psychology, is the one that gives SIPs much of their value.

This story first appeared in December 2013.

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