It is not just that you go for an SIP because you don't have a large amount to invest in one go, but even if you have money for lump sum investment, you would be advised to enter equity market in a systematic way.
There are two ways through which you may invest in equities and equity mutual funds (MFs) – lump sum investment and systematic investment plan (SIP). It is not just that you go for an SIP because you don’t have a large amount to invest in one go, but even if you have money for lump sum investment, experts would advice you to invest the money first in a debt fund and then switch the money in equity fund systematically through a systematic transfer plan (STP). But in case of fixed return instruments like time deposits in banks or Post Office, no one will stop you from investing in fixed deposit (FD) and ask you to do recurring deposit (RD) instead.
So, let’s analyse why it is advised to do SIP and avoid lump sum investments in equity, while there is no such advisory on investing in debt funds or FDs.
In case of FDs or debt funds or any other fixed income instrument, the return rises on a linear way over time. So, the more you invest at the lower point, that is at the starting of the graph, the higher will be your return. So, an FD is better than RD, and you would opt for RD only when you don’t have money for lump sum investment and rely on your regular income for periodic savings.
However, in case of equity, the graph doesn’t rise in a linear way and moves up and down every moment whenever a transaction takes place during trading hours, but despite fluctuations, the average curb rises over the long term. So, when you make a lump sum investment, you will see gains only when the net asset value (NAV) of the stock or the fund rises, else it’s a losing game, unless you stay for long term and let the long-term average curb rise, pushing the NAV up. So, in case of lump sum investment, you will gain only when the NAV moves up. Hence, lump sum investments may work nice for you, if you able to invest at the bottom of market cycle. But the pity is that nobody can say when the market would touch the bottom and you may continue to lose opportunities by waiting for that illusive bottom.
On the other hand, in case of SIP, you invest same amount of money periodically, say monthly. As the market continues to fluctuate, some of your investments may be at a higher NAV and some at lower NAV. When the NAV is higher, your fund value will move up, but you will get lower number of units as the price is high. On the contrary, when the NAV is low, your fund value will fall, but you will get more units as the price is low. This will make the average cost of you investment reasonable and you may accumulate more units than what you get through lump sum investment over a period of time. This concept is called rupee-cost averaging, which works fine for SIP by keeping the cost of acquisition lower, resulting into higher gains at the time of redemption.
Let’s take an example to make the things easy to understand.
For example, X makes lump sum investment of Rs 1,00,000 at an NAV of Rs 500 and gets 200 units. On the other hand Y invests Rs 10,000 for 10 months at NAVs of Rs 500, Rs 550, Rs 500, Rs 400, Rs 200, Rs 250, Rs 350, Rs 400, Rs 500 and Rs 600 and gets 20, 18.18, 20, 25, 50, 40, 28.57, 25, 20 and 16.67 units respectively. So, total number of units Y gets through 10 installments of SIP is 263.42 units, which is more than 200 units that X got through lump sum investment. So, while the average NAV at which Y invested his money is Rs 425, that of X is Rs 500.
If both of them redeem their units at an NAV of Rs 800, X will get Rs 1,60,000 (i.e. Rs 800×200), while Y will get Rs 2,10,763 (i.e. Rs 800×263.42) against the same investment of Rs 1,00,000. However, if the market continues to rise in a linear way like in case of FD or debt funds, X will be the gainer as every subsequent investments of Y will be at a higher NAV, resulting in accumulation of lesser number of units and lesser return.
So, SIP is better than lump sum investment for equities, where the NAVs fluctuate, providing opportunity for generating higher returns through periodic investments.