SIPs reward only the faithful!!

One of the less foreseeable results of last two years' turmoil on the stock markets has been that many investors are loudly questioning the efficacy of SIPs. One such person I met (a typical case) started off by claiming that SIPs were no good and that he had barely broken even on SIPs in a number of funds over the last four years. This seemed odd because the funds he named had done quite well. I quizzed him further and it turned out that back in 2008, when the markets had crashed, he had immediately stopped all his SIPs. However, he had restarted all the SIPs in August 2009.

Observant readers would have realised that this investor had basically done it to himself. He had invested in a manner that was guaranteed to shield him from any possibility of making money. Unfortunately, this mistake is way too common. The underlying problem is the increasing belief among people who skim the financial media that SIPs are a magical device, akin to the blessings of a god man, and are thus guaranteed to produce profits no matter when. They can stop whenever they feel like and start whenever they feel like and the God of SIPs will protect them.

The basic idea behind SIP, what the Americans would call SIP 101, is that while the general direction of an investment (a fund or even a stock) is upwards, it is not possible to reliably predict the actual fluctuations that it may undergo as part of its general trend.

Instead of trying to time one's investments, one should regularly invest a constant amount. As time goes by and the investment's NAV or market price fluctuates, this will automatically ensure that when the price was low, you ended up purchasing a larger number of shares or units. Eventually, when you want to redeem your investment, all the units are worth the same price. However, because your SIP meant that you bought a larger number of units whenever the price was low; your returns are higher than they would have been otherwise.

That's the way it works. Usually! However, you have to allow it to work by going on investing when the market is low. That's the most important part. At one level, SIPs are nothing more than a psychological trick to make you invest when the market is low. The whole point of investing is to buy low and sell high. If you stop your SIPs when the markets are low and then restart them when they have risen, then you have done the exact opposite of what SIPs are supposed to achieve, and you will get the exact opposite of good returns. Apparently, during the last two years, a lot of people actually did this.

Of course, there are circumstances in which a lump sum investment can (in hindsight) prove to be better. This happens when during a given period; the equity markets keep rising and never fall below the level they were at the beginning of that period. In such a case, a lump sum investment made at the beginning of that period will turn out to have the maximum gains because the buying price was the lowest at that point. The last one year (March 2009 to March 2010) happens to be one such period. However, over any longer period, such cases are rare. Generally, over a long period of time, the ups and downs of the market will ensure that SIP has the better returns.