If the market is volatile, a lump-sum investment can bear a negative return even in the long-term, but SIPs can still give you an excellent return
Mutual funds offer great flexibility to investors in terms of selection of asset classes and modes of investment. That being said, it won’t be wrong to argue that the selection of asset classes isn’t very difficult if you carefully analyse the requirements of your financial goals. But a slightly overlooked, yet equally important, aspect of mutual fund investments is the choice of the appropriate mode of investment.
There are two ways to invest in mutual fund—lump-sum or the Systematic Investment Plan (SIP) mode. It’s important to look at your risk appetite, market situation, the type of underlying asset class, and other factors before selecting the appropriate mode of investment.
Let’s check out the pros and cons of both these investment modes to ascertain which one suits your requirement better under various situations.
Pros and cons of lump-sum investment
One of the key benefits of a lump-sum investment is that it can offer very high returns, provided you time your investments well. However, it’s next to impossible for a retail investor to identify the right time to invest. If your timing is off, you could incur significant losses that may take months or years to recover from. You should opt for the lump-sum route only if you have a high risk appetite and are prepared to wait long periods to get returns.
Higher the risks, higher the rewards. If you have a low risk appetite but still want to consider the lump sum route, go for debt investments where the returns may be moderate and the chances of losses are lower. For example, a liquid mutual fund is a good instrument to park occasional windfalls. Those nearing retirement are especially advised to try the lump sum route with debt investments only.
Pros and cons of SIP investment
An SIP investment, on the other hand, allows you the benefit of rupee cost averaging in the long-term. An SIP allows you to buy a mutual fund at multiple price points, thus helping you lower your purchase costs and thereby increasing your chances of earning profits. An SIP with a longer investment tenure is likely to offer better results than an SIP with a shorter duration.
Investing through SIPs protect the investment from volatility in the long-term. You can build a big corpus in the long-term by investing in instalments every month. When the market falls, you get a chance to buy more units at a lower net asset value (NAV). On the other hand, when the market is high, you can book profits and cash out. Thus, your investment portfolio always remains close to the profit line in the falling market, and the portfolio gets a good return when the market turns positive.
How to invest in different market situations
When the market is expected to grow: SIPs may not give you a high return compared to what a lump-sum investment can offer when the market has bottomed out and is expected to rise rapidly. For example, if a mutual fund’s NAV is Rs 100 and it is expected to reach Rs 200 in three years, you can get a high return if you invest the entire fund at a Rs 100 NAV. However, if you invest through SIP mode, your average NAV-buying level would go up; hence, your ROI can fall significantly.
When the market is uncertain: If the market situation is volatile, or if you feel that that the market may witness a downward correction, investing through the SIP mode is a better option. If the market is volatile, a lump-sum investment can bear a negative return even in the long-term, but SIPs can still give you an excellent return.
For example, say, the current NAV of an equity fund is Rs 100, but it falls to Rs 70-80 levels in the next two years, and recovers to Rs 100 in the third year. Now, let’s check the scenarios. If you had invested through an SIP, you would have earned a positive return, however, if you had invested a lump-sum amount at Rs 100 only, you would have fetched zero returns. This happens because SIPs allow you to invest even when the market is down.
The author is CEO, BankBazaar.com