Putting in money regularly through SIPs rather than trying to time a lump sum investment can help one become a more disciplined investor

A Systematic Investment Plan (SIP) is an investment option offered by mutual funds to people where they can put in small amounts periodically instead of lump sums. They can do this by directly debiting a fixed amount of money from their bank accounts and investing in a specific mutual fund and allocating several units according to the current Net Asset Value (NAV). The frequency of investment could be anywhere from weekly, to monthly or quarterly.

There is no fixed period of investment in a SIP and it could range from as small as six months to forever. However, the shorter the investment period in equity mutual fund SIPs, the higher the potential gain. However, this is not without a higher risk. Research shows that there is a 16 per cent chance of losing more than 20 per cent in an equity mutual fund over a six-month horizon, whereas, there is a 90 per cent chance of positive returns in an average equity fund SIP of three years or more, making long-term investments more desirable.

Although most investors associate SIPs with equity mutual funds, investments into debt SIPs can be as effective. One of the fundamental principles of investing is to make money work as soon as possible. An investment needs time to grow, so the longer the money is in the market, the more chance one has of achieving one’s goals. An SIP is an option for small investors who want to take advantage of investing for a longer-term but cannot put in a large amount or a lump sum. Surprisingly, sometimes making regular and small investments in the form of SIP can work in the favour of small investors, because of a concept known as “Rupee Cost Averaging.”

Rupee Cost Averaging is an approach in which a person invests a fixed amount of money at regular intervals. This, in turn, ensures that they buy more shares when the prices are low and less when they are high. Let’s take an example. Suppose Ram has a lump sum of `10,000 that he wants to invest in a particular stock or fund, valued at `100. He has two options: First, he can invest the full `10,000 in one go, buying 100 shares, at `100 each. But by doing this Ram is fully exposed to the movements of the market and the value of his investment will rise and fall in line with any share price changes. His second option is to invest his money gradually and Ram may choose to invest `1,000 a month over 10 months. If the stock price stays the same, he will be able to buy 10 scrips each month at `100.

However, since share prices fluctuate frequently, regular investments by Ram will increase his buying power when the share price falls and he ends up buying more stocks and vice versa. With a drop in the share price to `90, he can buy 11 shares, whereas if it rises to `110, Ram will end up with nine.

Hence, by regular, small and pre-determined value of investments, Ram would be in a position to buy more shares when the price falls, thereby bringing down the average cost of purchase. When the stock price recovers to `100 in the last month, Ram’s original investment would be worth `10,300. This means Ram would be `300 richer by investing regularly, compared to a lump sum investment in the first month by buying 100 shares.

However, there is a flip side to it as well. Ram could also lose money if the share price moves up and he ends up purchasing at a higher price for most of the months. However, we all know that stock markets rarely move in a straight line and price fluctuations are the norm rather than an exception.

By systematic investments over some time, one can invest across a range of prices and effectively end up paying the average price over a fixed period, which can help smooth out market volatility. Trying to buy an asset when it is considered cheap, which is known as market timing, is tricky even for the most experienced investors. Just because a share has already fallen steeply in value, doesn’t mean it won’t drop further. Because of many market forces at play, nobody can predict perfectly how and when the price would change.

The decision to invest should be based upon market conditions and putting in money regularly through SIPs rather than trying to time a lump sum investment, can help one become a more disciplined investor and earn better returns in the long run. SIPs help in hedging the risk of getting the market timing wrong. They are also a good option for people with a regular income who want to allocate a fixed amount for mutual funds every month. Further, the choice of mutual funds should be based on one’s risk appetite and investment objective.

 (The writer is Assistant Professor, Amity University)