The reason why SIPs work: 'Rupee cost averaging'SIP or systematic investment planning is good. Invest through SIPs. These ideas have been spread far and wide among the investing public and lakhs of people, to their credit, are steady SIP investors. However, many people aren’t told clearly why SIPs are good and why they are better than lump sum investments. As a result, many people start and stop SIPs as per market conditions, defeating the whole point of SIP investment. The answer lies in the concept of ‘rupee cost averaging’.

What is ‘rupee cost averaging’?

The rupee cost averaging is the averaging of your purchase price. Investing in a lump sum will give you the prevailing NAV at the time of your purchase. Eg: If you invest Rs 1 lakh at a NAV of 20, your purchase price or rupee cost is 20.

If you do a SIP, your purchase price is the weighted average of the NAV on each installment. For instance, instead of Rs 1 lakh in one go, let us assume you invest Rs 10,000 over 10 months as follows:

Month NAV Units
1 20 500.0
2 19.7 507.6
3 19.2 520.8
4 19 526.3
5 18.8 531.9
6 19 526.3
7 19.2 520.8
8 19.5 512.8
9 19.8 505.1
10 20.1 497.5
Average Purchase Cost 19.43

Your purchase price is much lower at 19.43, lower than the 20 you would have got for your lump sum.

In this scenario, the market has declined before recovering. If the market instead keeps going constantly higher from the time of your purchase, a lump sum will do better than a SIP. However, this is very difficult to predict.

In addition, missing out on a few gains in a rising market is not as stressful as watching the value of your investment fall, in a sinking market. The latter scenario causes people to panic and they pull out their investments at a loss. This is why SIPs work better in the long run rather than timing the market.

Author
Neil Borate

Neil Borate is Deputy Editor, RupeeIQ. He can be contacted at neil@rupeeiq.com.