Mutual funds are investment vehicles that help investors choose schemes that offer a range of solutions to help them attain their financial goals. One can make lump-sum investments in mutual funds or buy into them through staggered modes such as a systematic investment plan (SIP).
The former is a one-time investment while an SIP is a more disciplined approach where one makes a standard, small payment at regular intervals. It inculcates the habit of saving and building wealth for the long term.
Importance of systematic investment
Lump-sum investment is suitable in a scenario where the trend is clear; for instance, if you are sure the market will rise by 30 per cent over the next year, you could make a lump-sum investment. But given the volatile nature of the equity market, it is difficult to predict its movement. If the market declines significantly after a lump-sum investment, there could be sizeable erosion. And one-time investments may not be feasible for many investors due to limited fund availability.
SIPs work well irrespective of market conditions. Using this route also helps investors accumulate more units when the market is falling.
Advantages of SIPs
Investing in a systematic way helps reduce risk through rupee cost averaging, allows you to invest small amounts of money, aligns with long-term goals, gives investors the power of compounding and prevents bad market timing.
Rupee cost averaging is a benefit obtained when investing a fixed amount of money in the equity market at regular intervals, like an SIP. This ensures that the investor can buy more units when prices are low and less when prices are high. This helps reduce the average cost of your investment over time and increases your profit.
To illustrate this, let’s compare the two investment modes — SIP and lump-sum — with the same invested amount. Taking the SIP route, Investor A put in ₹1,000 every month in an equity mutual fund starting in January (total amount invested was ₹12,000) while investor B invested a lump-sum of ₹12,000 in the same fund in the same month.
The Table on ‘Rupee Cost Averaging’ illustrates how their respective investments would have performed from January 2016 to December 2016.
At the end of December, investor A accumulated 689 units through SIP investment while investor B holds 658 units. Investor A bought more units than investor B when the price was low and less when the price was high. Over a period of time, the market fluctuations averaged out, pushing down the average cost of investment.
In a rising market, the SIP investor may accumulate an almost equal, or lower, number of units than the lump-sum investor. But SIPs generally work well for the long-term time horizon, which includes many market cycles.
No need to time the market
Ideally speaking, most investors want to buy stocks when the prices are low and sell them when they are high. But timing the market requires effort and is risky. A timing strategy usually results in huge sums of investment at uncertain intervals while the SIP achieves a steady rise in corpus and compounding.
Start with a small amount
Most mutual fund companies allow low SIP instalments, such as ₹50, ₹100, ₹250 and ₹500 with daily, weekly, monthly, quarterly or yearly frequencies. It is similar to a regular savings scheme, such as a recurring deposit with a bank.
SIP is the perfect tool for people who have a specific financial requirement. By investing an amount of your choice every month, you can plan for and meet financial goals, like a child’s education, a marriage in the family or a comfortable post-retirement life.
The chart below illustrates how a little every month can go a long way. It shows an investment of ₹10,000 made every month for the last 10 years through the SIP route in HDFC Mid-cap Opportunities Fund. The amount invested so far is ₹12 lakh and the current value of the investment is ₹41 lakh.
Power of compounding
One way to explain the power of compounding is that the interest you earn from your principal also earns interest. On the other hand, simple interest is always based on the original principal balance and ignores the gains made through interest.
By investing in mutual funds, one can reap the benefits of compound interest. Opting to reinvest dividends derived from mutual fund results in purchasing more shares in the fund. Compounding works well if the investment is allowed to grow for a long time.
The chart below shows the growth of investmentsmade in the Sensex in various time-frames through the SIP mode. No doubt, investing through SIP for a longer time-frame achieved better results than those made for shorter periods.
SIP or lump-sum?
Investors should not compare the performance of a lump-sum investment with an SIP. They are different concepts and this comparison could lead to wrong conclusions depending on the entry time in case of lump-sum investments.
One can say that over a sufficiently long time, SIPs will do better. However, lump-sum scores over SIP in a rising equity market as cost averaging does not work in SIPs during such periods.