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Why not to compare SIP and lump sum returns

A question that is frequently asked by Mint Money readers is whether a lump sum investment in an equity mutual fund (MF) or a staggered outlay through a systematic investment plan (SIP) will fetch a better return.

Consider this: If Rs5,000 was invested every month through an SIP in HDFC Equity Fund (HEF) since 1 January 2008, when equity markets were skyrocketing before it tanked, you would have got a return of 39.2% by end-2010. However, if you had invested the entire Rs1.80 lakh as a lump sum, you would have earned just 11%. A similar SIP, however, started on 15 March 2009 when markets started to rise, would have yielded 43% till date compared with 69% if you had invested the entire amount as a lump sum. We compared SIP and lump sum returns for a couple of large-cap-oriented equity funds, HEF and Templeton India Growth Fund, and a mid-cap-oriented fund, IDFC Premier Equity Fund, over the past five years and the difference in returns were negligible.

Also See | Which one is better? (Graphic)

Getting down to basics

An SIP is a mechanism of investing in equity funds in a periodic manner, either every month or quarter. Many fund houses also offer daily SIPs. In a typical SIP, you choose an amount that you want to invest periodically. Once the amount is chosen, it remains constant irrespective of whether markets go up or down. Say, you choose to invest Rs5,000. In the first month when the net asset value (NAV) was Rs10, you would get 500 units (Rs5,000/ Rs10). In the next month if the NAV goes up to Rs12, then you would get 416.67 units but if the NAV goes down to Rs8, you would get 625 units. There are flexible SIPs too—a new entrant in the Indian MF industry which has gained popularity since last year—whereby instalments can be changed depending on the market levels. So when the markets drop, the instalment amount automatically goes up (that also leads you to buy more units). A lump sum investment, however, entails that the entire amount is invested up front.

More units

There are two reasons for the deviation of performances, especially in the short run, between SIPs and lump sum. Firstly, market direction determines how much money you make. An SIP in choppy markets would accumulate more units when markets drop and less units when markets rise. For instance, if you had invested Rs5,000 every month through an SIP in HEF starting 1 January 2008 and stayed invested till 31 December 2008, you would have accumulated 1,036 units for a total investment of Rs1.80 lakh. However, if you would had invested the same amount as a lump sum on 1 January 2008, you would have got only 818 units. "An SIP is devised in such a way that you don’t time the market; it does the work for you irrespective of where the market levels are", says Anil Rego, chief executive officer, Right Horizons, a Bangalore-based financial planning firm.

For the same reason, the "number of units" phenomenon works against an SIP in rising markets. If you had put Rs5,000 every month through an SIP in HEF starting 15 March 2009 and held the investment till date, you would have earned a return of 20% against 50% through a lump-sum investment, assuming you invested the entire corpus on 15 March. Reason: The SIP investment would have got you 529 units against 949 units in the lump sum investment.

The other reason behind the difference in performance is the tenor. If you opt for an SIP for a year or so, SIPs would typically underperform lump-sum performance. An SIP of Rs5,000 made in Birla Sun Life Frontline Equity fund would have made a loss of 1.6% against a return of 8.4% through lump sum investment. Says Akshay Gupta, managing director, Peerless Funds Management Co. Ltd: "The best way to make SIP work is to opt for long-term monthly SIP and allow it to grow for a period of 10-15 years."

What you should do

Look at your cash flows and tenor. "If I have a monthly income, SIP makes more sense. This also means I wouldn’t have the entire lump-sum money at my disposal right at the start; hence it doesn’t work in this case", says Amit Trivedi, CEO, Karmayog Knowledge Academy, a Mumbai-based MF training institute.

But SIP has bigger benefits. You don't have to think about timing the market. When markets reached their peak in January 2008, financial planners say many investors invested lump sum only to panic later and withdrew when markets started to fall. If, on the other hand, you had started off with your SIP during that time, you would have benefited despite markets falling 52.5% in 2008 and then rising 114% between March 2009 and December 2009. An SIP of Rs5,000 in Templeton India Growth fund from 1 January 2008 till 31 December 2010 would have yielded 31.8%. If, on the other hand, you had invested the entire amount (Rs1.80 lakh) as lump sum, it would have returned only 7.8%. "SIPs not only give you better returns but also allow you to take advantage of volatility which is a inherent risk in equities", says Kapil Mokashi, assistant manager-equity advisory, Sharekhan Ltd.

Rego claims that most investors invest lump sum at higher market levels. “An SIP does the opposite. It buys more units when markets are down and lesser units when markets are at a high."

Tip: Remember to continue SIP in volatile markets, even if markets drop. Mokashi says that people go wrong in SIPs (they stop their SIPs in turbulent markets) because they do not understand the concept. Rego adds: "Increasing tenor of SIP helps as it negates volatility. The probability of making a loss in, say, a 10-year SIP is half of what it is if you do a lump sum investment. "Does that mean lump sum doesn’t work? "It works", says Mokashi, "but only if you have a long-term horizon and would look at returns after five years". The choice is yours.