Investing for Beginners: What is SIP and which is better - Lumpsum or SIP?

This is one of the most frequently asked questions by new investors. Let us first understand what an SIP is and how is it different from lumpsum.

What is an SIP?

SIP stands for Systematic Investment Plan. In plain English it simply means investing a fixed sum of money (say Rs 10,000) every month on a fixed date (say the 7th of each month).

When you set up an SIP, the money is debited from your account every month automatically and invested in the Mutual Fund without you having to do it manually. So the only difference between SIP and lumpsum is that SIP is automatic whereas lumpsum is manual.

The only difference between SIP and lumpsum is that SIP is automatic whereas lumpsum is manual.

There is absolutely no monetary difference between you doing a lumpsum investment of Rs. 10,000 every month on the 7th on your own in a Mutual Fund vs you setting up an SIP of Rs. 10,000 for the 7th in the same Mutual Fund.

Everything - from returns to tax implications - remains exactly the same.

Now that we have cleared that up, let us turn to the original question.

Which is better - Lumpsum or SIP?

In the light of what we just discovered about SIPs, let us rephrase the question: Which is better - investing manually or investing automatically?

Now as we said earlier - if you invest manually the same amount on the same day every month as your SIP without fail, then there is no difference between investing manually and investing automatically. The two are the same.

The only problem is that it is very difficult to do it manually with such discipline. Sometimes we plain forget, sometimes we are just feeling lazy, sometimes we might be travelling and not be able to do the transaction and sometimes we might just think of skipping this month because we have already spent that money.

If it were just the above reasons separating the two modes of investing the answer would be clear and there would not be much confusion. It would have been akin to asking - is it better to go out and buy milk or newspaper every morning or to have the same delivered to your doorstep every morning automatically. You don't see any blog posts or news articles being written comparing the two delivery modes for buying milk or newspaper.

So the reason why this is still a question that people tend to ask is because stock markets are volatile - hence there are times when they do well and there are times when they don't. This leads us to believe that if we could somehow avoid the bad times and invest only in the good times (i.e. when the 'market conditions' are right) we would do better than a seemingly dumb strategy of investing the same amount on the same day and that too every month.

The question of Lumpsum vs SIP is the same as the question of market timing

The catch is that in all likelihood you probably won't because it is very difficult, if not impossible, to time the market.

Is it possible to time the market?

We see a lot of market experts on TV and financial media making short-term predictions - and most of them are smart people - so we think if we just followed what they said then we will be able to pull it off. If you actually sat down and tallied their prediction record, you would find it no better than a coin-toss. This does not mean that they are stupid, this is just how dynamic the markets are.

Or sometimes things seem very 'obvious' - e.g. Trump is a nut-job with some extreme views on economic policy, so if he wins the global markets will go down - this was the conventional wisdom. And so far, it has turned out dead wrong. Similarly, when demonetisation happened everyone thought the Indian markets will crash. As of today they are higher than they were the day just after demonetisation. May be this is just the lull before the storm and some time later the markets will actually crash because of demonetisation or Trump. What will happen in the future we don't know - but how long will you wait for your theory to play out?

And you will have to be doubly right - once about when to stop investing and then again when to re-start it, for markets do bounce back to their old levels and then go higher. You don't want to be left behind when that happens, do you?

The odds are heavily against us in trying to time the market. There are no obvious good or bad times to invest. And what seems obvious can turn out to be completely wrong in hind-sight. Markets are very dynamic and they react swiftly to news - sometimes in very unexpected ways. Sticking to a dumb strategy of SIP is daunting enough given the ups and downs - there is no need to complicate it further by trying to time the markets too.

So what's the verdict?

Given the fact that we are at times lazy, forgetful, emotional and prone to fall for the 'obvious' stories about the economy and the markets - we should avoid timing the market and invest as and when we have the money.

Avoid timing the market and invest as and when you have the money.

For a lot of us who are salaried and have steady income, this naturally leads to the option of setting up an SIP from our monthly savings.

What about the money you already have?

What about if you already have a sizeable amount in your bank account, say 2 lakhs, which you want to invest? Should it be done in one go or should you make an SIP out of it and spread it over several months? Which will give you better returns?

A lumpsum would turn out to be better if after you have invested the market goes up. Doing a lumpsum would get you in at a lower price than buying at increasing prices via SIP.

An SIP would turn out to be better if after you have invested the market goes down. Doing a lumpsum would get you in at a higher price than buying at decreasing prices via SIP.

As you can see, it all depends on what happens after you invest. And since it is very difficult to predict which way the market will go soon after you have invested, the best we can do is to expect the market to follow its average pattern and plan accordingly.

And what does the stock market do on average? It goes up. Stock market on average gives positive returns (about 12-14% annually i.e. 1% per month on average). If they did not give positive returns on average there would be no point in investing at all, let alone via SIP or lumpsum.

On a monthly basis, the stock markets are up 55% of the time and down the rest 45% of the time i.e. it is more likely that the stock market will have moved higher next month than lower. So if you spread out your investments over several months, the chances that you would end up investing at increasing prices are somewhat higher than the chances of catching lower prices. So spreading it over the months should on average lead to marginally lower returns.

To make it even clearer, consider an extreme example - if it is better to spread then why spread it just over a few months? Why not spread 2 lakhs over 20 years investing only Rs. 10,000 per year instead of investing all of it in the first year? Stated this way it becomes obvious that you are going to lose out on a lot of time (and returns) waiting while your money sits idle in your savings account.

Markets go up with time, on average, despite the volatility. Hence, waiting/delaying = losing.

Well, theory is theory. In practice we are all emotional investors. We don't want to feel regretful if we invested all our 2 lakhs in one day and then over the next month, the market goes down 5% (even though it is more likely that the market goes up 5% than down 5%.) And research shows that the pain of loss is felt twice as strongly as the pleasure of a gain.

So where does that leave us? How do we balance theory with the practicalities of our emotions? Here is a very crude idea - if the investment amount is high compared to your monthly savings (e.g. the investment amount is 2 lakhs and your monthly savings are just Rs. 10,000), then spread it over a few months investing not more than 3-4 times of your monthly savings in one go (i.e. say Rs 30,000 each month) and investing everything within a year tops.

On the other hand, if the investment amount is not very high compared to your monthly savings (e.g. investment amount of 2 lakhs with monthly savings of Rs 50,000) then you could just invest all of it in one go also.

The limited rationale behind this (after all, we are trying to cater to our emotions and not logic) is that if the individual lumpsums are sized according to our potential/ongoing SIPs, then even if we end up investing at a bad time, our SIPs would be enough to smoothen out the adverse impact in a few months.

What did you do when you had a big chunk of money to invest? Did you invest all of it in one go or split it into monthly SIPs? Do let us know in the comments below.

This post first appeared on Quint here.