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Tuesday, December 15, 2009

Mutual Funds - SIP Is Best

The systematic style of investing in mutual funds is actively promoted by practically everyone who gives advice about mutual fund investing.

Mutual Funds - SIPping Is BestWhether these are mutual fund companies, advisors, or the media, an SIP is supposed to be the holy grail of mutual fund investing. Unfortunately, there seem to be a growing number of investors who have cottoned-on to the notion that SIP investing is some sort of magic. There are two widespread misconceptions about SIPs: some investors believe that an investment through the SIP route cannot have poorer returns than a lump-sum investment made at the same time that the SIP was started. The other, more extreme point-of-view is that you can’t make a loss in an SIP, no matter what. Both are equally wrong, or perhaps the second one is more wrong than the first one.

The basic idea behind an SIP 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 net asset value (NAV), or market price, fluctuates, it will automatically ensure that when the NAV 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 otherwise have been.

That’s the way it works, usually. However, 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 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 is one such a period. Generally, over a longer period of time, the ups and downs of the market will ensure that an SIP has the better returns. Moreover, SIPs mirror the actual fund flows of salaried people. They don’t generally have money available in large chunks to be invested as and when they feel like investing.

Beyond the arithmetic of returns, there is another reason why SIPs make sense. They are a great way to override the normal psychological instinct to stop investing when prices fall. The normal tendency is to invest more when prices are high and to stop investing when prices fall. This is the opposite of what is the most profitable way of investing. SIPs force you to follow the opposite approach, much to your eventual benefit.

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