Do SIPs really work?

A Systematic Investment Plan (SIP) is an investment plan that allocates a fixed sum of money (usually the same amount) at a regular frequency (month/quarter/etc) to an asset class (like stocks/bonds/gold/etc). For example, every month you invest, say, Rs. 25000 in a mutual fund and keep doing this month after month.

SIP is an idea that the professional investment community loves to push. Every day we read so called experts advising people to go in for SIPs. Mutual funds come out with advertisements urging investors to buy a SIP in their companies. It is common wisdom that SIP is a good way to make money over the long term.

SIPs look like a great idea. It is convinient and affordable for the average investor. All you have to do is to simply put away a small sum into the markets - the same amount every month. When prices are low, you get a higher number of shares or mutual fund units. When prices are high, you get a smaller number of shares/units. A classic case of rupee cost averaging, which essentially is the foundation of a SIP! It seems like a great way to take market exposure and a great way to make money.

There is just one little thing. It doesn't work!!

Have a look at empirical evidence. If you had invested Rs. 10000 in the BSE Sensex on the first trading day of every month from January 1992 till April 2003 (more than 11 years) your total investment of Rs. 13.6 lakhs would have become 12.33 lakhs giving you a -1.8% return compounded annually over the period. You would have actually lost money. Compare this with a one-time investment in the Sensex in January 1992, which would have given you a 4% (positive) annual return. Add transaction costs and the performance of the SIP would look worse.

How about the period in the current bull run? From May 2003 till date (27 June 2008), the Sensex has gone up at the rate of 34.6% compounded annually. In contrast, the same SIP would have invested Rs. 6.2 lakhs and would have made Rs. 11.17 lakhs at an annual compounded growth rate of 23.7%. Not bad, but still lower than the return on a lump sum investment!

One instance where rupee cost averaging (and hence a SIP) can work in the long run is, if for the first 7-8 years prices keep falling and take off steeply in the latter part of the investing period.

Rupee cost averaging - like diversification- does not make you more money. It prevents you from losing more money in certain market conditions (like a falling market) than you would have lost otherwise. If that's good enough for you, fine. But if you are convinced that a market or asset will go up over time, rupee cost averaging does not make sense. In short, if you like an investment, simply go for it.