There are no guarantees for market-linked products. You could lose money in stocks, bonds and equity schemes, depending on when you buy and sell. What are the chances of losing capital through your SIPs? Look at the five-year periods between January 1991 and May 2012. There were 197 such five-year periods when you could have started your SIPs.

It might shock you to know that you would have lost money on 41 occasions. That is, there is a nearly 20% chance of losing money for running a SIP over five years. In seven-year periods, you would have met with almost the same fate. For the 10-year SIPs, the percentage chance of loss would get reduced to 15% but it still is there.

If SIP doesn’t work on many occasions, what are these occasions and can we spot them? Yes, by some rigorous back-testing.

SIP will work well over an investment period only if the two below-mentioned conditions are satisfied:   
Most of the investments are made at a declining phase of the market;
The market eventually turns up.

In this situation, every new purchase is made at a lower cost than the previous one, for several periods. Therefore, when the markets go up again, your average price would be lower than that of the initial purchase price. Thus, the investor would have made sufficient returns. Here is a chart to illustrate how SIP worked between 2000 and 2008. This is the best-case scenario for SIP, but not a typical one. But

SIPping smartly 3: When do SIPs Work?

Mutual fund distributors always harp on infallibility of investing through SIPs. Though the idea reaps returns, funds/markets have to satisfy certain conditions to make them work.
SIP will work well over an investment period only if the two below-mentioned conditions are satisfied:
•    Many of the purchases are made at a declining phase of the market;
•    The market eventually turns up.

While history may not repeat exactly the same way in future, it does give us little more confidence to follow a strategy whose success in the past was not random. So let’s look at when SIP worked. The five-year period from February 2000 to February 2005 was the best period for SIP, compared to a lump-sum investment —even though at the starting period, the market was at its peak. The Sensex dipped from over 6,000 to below 2,600 before moving back up again. A lump-sum investment at the start of the period would have earned you 4.27% whereas a SIP would have fetched you as much as 21.47% (IRR). This was a period, which boosted the returns for the seven-year and 10-year SIPs which started around the same time.

The volatile period from January 1994 to December 2003 was an ideal period as well, for SIPs. This period gave several opportunities to buy low. In this 10-year period, a lump-sum investment would have earned 5.73% whereas a SIP would have done better with an IRR of 9.27%. A five-year SIP between January 1995 and December 2000 would have returned 17.24% compared to a lump-sum, which would have gained just 9.75% in the same period.

What are the lessons? The value of your SIP—like your lump-sum investment—depends when you start and end with respect to the market. You cannot predict where the market will end up three, seven or 10 years from now, but what is within your control is starting the SIP when times are more favourable. Start your SIP when the market valuation is low, or at least not high —as is probably the case now. Does this sound like you have to time the market? True. But isn’t SIP touted to be a reason for avoiding market-timing, which is inherent in lump-sum investment? Yes, it is. But, as we have demonstrated, you cannot get great results by ignoring market valuation. If fund companies and distributors push you into SIPs, irrespective of the market valuation, it means that they either haven’t tested this or are not telling you the truth.

SIPping smartly 4: Using SIP for Lump-sum Investment-

SIP is useful for those who have a regular stream of earnings, saving money and have a long investment horizon. What about those who already have substantial fixed-income investments and want to move a lot of it systematically into risk assets like equity mutual funds? Surely, you would not want to put the entire sum into equity funds at one go. Should you distribute it equally over all the periods? Investing through a SIP seems a safer option. But, there is a way to do it. You may keep your money in the bank and start a SIP to the mutual fund you have chosen. However, you would earn a meagre 4% from your savings account.

Better still, put money in a liquid fund scheme and then create a systematic transfer plan by which your investment from your liquid fund would be systematically transferred to your equity fund. As liquid fund schemes invest in money market instruments, you could earn an average return of 6% per annum.

For the past one-year period ended 31 May 2012, these schemes returned an average of 9.30%; 10.57% was the highest return and 7.29% the lowest. The best advantage that liquid fund schemes have is, well, liquidity. There is no entry-load or exit-load and thereby you can put in cash and withdraw at anytime. If you had done a systematic transfer plan (STP) for the same periods we mentioned earlier, you would never have lost money in the seven-year and 10-year periods. In the five-year periods, your chance of loss would come down to 4%, compared to 15%—had you made a lump-sum investment. Only on eight occasions you would have lost money. These were periods when a lot of purchases were made closer to the market peak, raising the average purchase price. Even then the maximum loss was just 1.56% which (for the period September 1996 to August 2001). A lump-sum investment for the period would have gone down by 2.79%. The maximum loss registered through lump-sum investing was 7% whereas an STP would have ran a loss of just 0.40%. Therefore, you can improve your chances of coming out better than lump-sum investing using an STP method.

We tested this method with an equity scheme and liquid scheme of the same fund house for the period December 2006 to December 2011 when the index returned 2.31% and a SIP on the index returned 0.29%. Had you invested in the equity scheme through a normal SIP, you would have earned an annualised return of 3.49%. However, had you put your entire money in the liquid scheme and systematically transferred it to the equity fund, your annualised return would be as much as 7.12%.

SIPs for the Smarter Saver
You would like to start saving for a long-term goal, such as your retirement, for which you would like to set aside a small amount from your income each month. Investing in equities is the key for long-term wealth generation. But setting up a SIP is not enough. Consider this: your income is not going to remain the same over the coming years; it is going to grow. So, your SIP investments should not be of a fixed amount. It should grow. This would ensure that you save more and more each year. This is called growth SIP.

The chart Improved SIP is a comparison of a normal SIP and a SIP with growth option. In the growth option, we have assumed a 10% rise in the money allocated for SIP per annum. Apart from accumulating more wealth, your returns would have been 5% better in the 'Growth SIP' option for the period from December 2006 to December 2011.

SIP makes investors save regularly and takes away the emotion and uncertainty of investing under volatile market conditions and the temptation to time the market. But if you have a blind belief about SIPs, you will be sorely disappointed. Trying to time the market takes a lot of in-depth research, but you should also know that SIP often does not improve expected returns. The best action would be to avoid trying to time the market and to aim to make regular savings, but without committing themselves to an unnecessarily rigid SIP strategy. Remember, SIP is a risk management tool with a limited function. The function is to prevent you from investing lump-sum at market peaks and encouraging you to spread out the risk over time.

Some Facts & Myths about SIPs

Myth: SIPs prevent losses when done over long periods.

Fact: SIPs cannot prevent losses, even over the long term, if the markets are in a sideways phase

Myth: SIPs fetch higher returns than lump-sum investment

Fact: While the two are not comparable, SIP by itself doesn’t work to increase returns over the long term. It partly depends when you start and end your SIP
Myth: Even when investors have no idea what the market will do, they can expect to beat the market by using SIP

Fact: The basis for SIPs is the assumption that the market, on average, goes up over a long investment horizon. This assumption is true for a very long period (10 years or more) but may not be true for your investment horizon. There are no blind but safe bets in the market