All mutual funds encourage you to invest through SIPs. They promote it strongly, running campaigns for distributors to meet new SIP targets. It is beneficial for both of them. They get regular inflows on which they can charge fees (funds) and commissions (distributors). Most mutual fund schemes give the investor the option of monthly or quarterly investment. Financial planners and advisors advocate SIP probably because it has a veneer of a “method”. If something goes wrong, you can also blame a widely-accepted method. But beware; there are periods when SIP works and when it doesn’t, though we have not heard of fund companies or distributors tell you about when SIPs fail and why. Rigourous back testing done by Moneylife suggests that there are several periods when SIP will not work well or lumpsum investment will do better. If the market is mainly down, not up, all your accumulated units are marked to a low final value. Also, if the market mainly goes sideways. In this case, the average purchase price would closer to the final price. The returns will not be poor but not that great. In the third case, if the market is headed down from a peak formed by huge overvaluation, the average purchase price, goes up compared to the final value as the purchases are made at the market peak.
We tested the SIP strategy on the Sensex, over the period from January 1991 to May 2012. We compared the returns of a lump-sum investment made at the start of the period and a systematic investment of an equivalent amount made in the same period. The results: Both SIP and lump-sum performed equally over the one-year, three-year, five-year and seven-year periods. It might stun mutual fund companies and their distributors who blindly herd investors into a SIP regime, that in the three-year, five-year and seven-year periods, the probability of SIP beating lump-sum investment, taking any start point between starting from January 1991, would have been as good as tossing a coin! If this does not rattle all financial planners and advisors who blindly borrow ideas from the West and implement them here, we don’t know what will.
By increasing the investment term to 10 years, SIP did comparatively better, outperforming lump-sum investment on a greater number of occasions. We did a 20-year analysis as well, but due to the extremely low prices in 1991, lump-sum investing did better. Finally, in case of runaway bull markets, lump-sum will do better. One such period was from November 2003 to November 2008.
This five-year period provided no opportunity for an investor to buy lower than the previous purchase price, except towards the end—after the market crashed. Despite the crash, a lump-sum investment would have given a CAGR of 12.50% whereas a SIP in this period would have given an internal rate of return (IRR) of just 0.48%. However, it is unlikely that we may see such a period again for a long time.
Also read SIP can mean capital loss!