Understanding the pros and cons of SIP and lump sum investment strategies at different market cycles can help optimise returns.
By Parthajit Kayal & Renuka Venkataramani
Systematic Investment Plan (SIP) is the investment of a fixed amount of money through time at equal intervals, adjusting the number of units as average stock prices fluctuate. When the stock prices are high, fewer units are bought and when the prices are low, more units are purchased. SIP is a favourable investment strategy if there is time-diversification and the market is not too high. Lump sum (LS) investment is putting a substantial sum of money at one go in a mutual fund or a stock. LS investment performs well in the early stages of a bull market.
SIP is a desirable method as it takes advantage of the stock market’s ups and downs. This method might be advantageous if the stock returns are negatively auto correlated, as in the academic literature of mean-reversion theory.
Using this mean-reversion principle, SIP strategy is introduced in which the stock purchases (or units of mutual funds) are increased after a market decline and reduced after a market advance. It is particularly appealing when investing in volatile stocks over a substantial horizon.
In a normal situation, SIP does not really reduce volatility or raise returns. Relatively, LS investment strategy tends to have a higher return because it is more fully invested and has lower volatility because it is more uniformly invested. If the expected return is higher than the return from fixed income securities, LS investment is preferred to the SIP method. For example, immediately after the market crash in March end. Therefore, if there is an opportunity cost of not investing immediately then the optimum decision is to invest the entire sum that is available for investment. Dividing the large sum of money into small segments for future investment over an extended time period is not recommended especially when we are in the beginning of a bull market.
Average the cost price
The intent of using SIPs is to average the cost price per unit and also avoid buying high and selling low. SIP protects investors from trend chasing and portfolio churning, and avoids a single ill-timed purchase that might scare investors away from future stock purchases. If it is projected that equity prices will trend downward (when the market is overpriced), then SIP might beat immediate LS investing, but with this assumption, not investing in equities is likely to beat both SIP and LS strategy. SIP way of cost averaging is not optimal, but, in some circumstances, it might be a reasonable approximation.
To conclude, investing through SIP is in a way following market fluctuations and thereby believing the story what everyone else believes. It forces investors to follow herd mentality. SIP might help them to achieve average returns like index returns in the long run but can make them suffer in the extremes like a market crisis. If investors continue SIP during a crisis they will face loss in the existing investment and also miss out when markets recover. A fair understanding of market cycles and the pros and cons of SIP and LS investment strategies at different market cycles can make investors better prepared to effectively use both the strategies to optimise investment returns and reduce volatility.
Kayal is assistant professor & Venkataramani is researcher at Madras School of Economics