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SIPs are not necessarily less risky, or better for the long term

Systematic Investment Plans or SIPs are now touted around by mutual funds and advisors as the best way to invest in a volatile market, and that small investors must use that approach to enter the market. I don’t particularly deny that statement, but I feel that SIPs need a lot more history to prove themselves in India.

Read this personalfn article for an overview of why SIPs are recommended for investors. Very good points, mind you. But let me try and see if the results show the same as the theory.

India has very little historical data – since most mutual funds have existed only since 92-93. The U.S. has a far longer and perhaps richer history, so I have chosen to look up SIPs in the U.S. market, and the SIP concept there is called “Dollar Cost Averaging” (DCA).

Read this research paper on the subject that talks about DCA and how it compares with three other strategies: Lumpsum investing (putting money upfront), Buy and Hold (half in equities and half in t-bills) and Value Averaging.

The results, taken from data from 1970-1999, and also from 1950-1999 yields interesting results. The DCA strategy performs worse than Lumpsums for both large caps and small caps. Also, for small cap stocks, it does worse that all other strategies!

Secondly, look at the “standard deviation”, meaning the variation on either side from the average. This is an indicator of risk, since your returns may be higher or lower than the average by a big margin (high risk) or very less (smaller risk). The SD for Lumpsum investing is the highest, obviously, because you are investing in a high risk avenue (stocks) with upfront money. But DCA has a higher standard deviation than value averaging or buy and hold too – which means, it has higher risk than them – this, additionally, indicates that for a lower long term return, you are taking on a higher risk.

And lastly, the paper states that SIPs are not necessarily less risky. But they may also not appeal to the “behaviour” of the investor, which is why most SIPs are advised. Meaning, most advisors feel that you should not attempt to time the market and go for an SIP regardless of ups and downs, so that you don’t feel really bad if the market goes down since this strategy averages the cost of purchase during lows.

But if you look at the returns and the risk you are taking, you may find lower returns for higher risk using this strategy, which obviously does not help your mood!

There are disadvantages of SIPs that very few people talk about. You need to provide either cheques or an ECS mandate upfront to transfer a fixed amount per month to the fund, on a fixed date. Most investors will invest in multiple funds, on a fixed set of dates (many mutual funds only offer certain dates – 5th, 15th, 25th etc. – for SIP investments)

The first disadvantage is that you can’t easily stop one intermediate payment. I usually tend to take holidays that are not inexpensive. So I may need money one month to spend well, and I don’t want to invest that month – stopping SIP payments is a huge nightmare, especially if you have invested in many mutual funds. Plus if you did stop one payment, you have to come back and restart all your SIPs because the fund assumes you have stopped the strategy completely!

Secondly, the amount is fixed. So you can’t choose to invest more when you feel the market is undervalued, or less when you think it’s overvalued. This, for an active investor, is a problem. For instance, I have invested much more in June 2006 than in November, simply because I thought the market was better. I have not yet invested much this month, but based on how it goes I might put in a lot more money in the end of December. This is not available in an SIP scenario.

Thirdly, the fixed dates don’t give you much of an advantage. If you are an active investor you may want to invest ON the last thursday of the month, because that is the day futures are exercised and you can figure out how much you want to invest based on the rollover. Nobody offers you that facility.

Finally, there is an issue with cash flow: I personally have committments that are either sudden or annual. Like taxes, or holidays or emergencies. I need to have the flexibility to address investments based on my cash flow, which is not very predictable. SIPs take away that flexibility from me.

In conclusion, I think SIPs are a good investment for many (I will post about that later) but if you are an active investor you might want to consider some of the negatives before you plonk a ton of future cash flow into this investment.

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