SIPs: It’s about behavioural investing

SIPs: It’s about behavioural investing


We had a rather interesting debate recently with an investor who refused to see the significance of such investing.

He argued that SIP is like rupee-cost averaging and that such a strategy is suboptimal.

This article shows the subtle difference between SIPs and rupee-cost averaging.

It also discusses the behavioural bias that investors suffer from that make it difficult for them to take rational decisions. It finally suggests how SIP helps investors moderate this bias.

Rationally suboptimal?

SIP is different from rupee-cost averaging (RCA). In RCA, an investor has a choice of making a lump-sum investment or a specified sum each month so that a total amount is invested over a period of time.

An investor setting up an SIP does not have such a choice.

Rather, she simply invests a specified sum of money each month, presumably, from her monthly earnings.

In RCA as in SIP, investors will buy more units in a mutual fund when asset prices decline and lesser units when prices trend up.

Research shows that RCA or dollar-cost averaging as it is called in the US is sub-optimal. One argument is that lump-sum investing provides higher returns when the market trends up and better cash returns when market declines.

But what if investors wanting to start an SIP instead accumulate money each month in cash-equivalent account and then invest lump-sum in the desired asset class?

Such an investment will earn sub-optimal returns till the cash equivalents are invested.

Besides, the investor should possess market timing skills to switch from cash equivalents to the desired asset class.

And even if the lump-sum investment plan provides superior returns, there is a strong behavioural reason to set-up SIPs.

Behaviourally optimal


Classical finance assumes that investors are rational.

But evidence shows that investors are normal.

This means that investors are swayed by emotion and cognitive biases which may seem irrational in the world of classical finance.

SIP has to be seen in the light of these biases.

Consider what behavioural economists call as transaction utility.

This refers to the bargain value of a purchase, which corresponds to pride and regret.

A good bargain would mean that pride is greater than regret; a bad bargain the reverse.

Now, there is a strong relationship between regret and responsibility of choice.

Suppose an investor has a wide range of financial products to choose from.

The pain of regret is greater when an investment that she chooses goes down; for the responsibility of choosing and failing rests with the investor.

It logically follows that investors will continue to take investment exposure as long as they can reduce regret.

And they can reduce regret if they can lower their level of responsibility.

Decision made under strict rules reduces the level of responsibility.

SIP is one such rule; for it is an automatic investment plan that buys assets every month with a fixed sum of money.

There is, hence, a strong behavioural reason to set-up SIP.

Setting-up SIP


Suppose an investor wants to set-up an SIP of Rs 10,000 a month on an index fund as part of her core portfolio. Typically, the investor will have a choice of three to five dates to set up the plan.

To ensure that the SIP has exposure to all price points, an investor can break Rs 10,000 a month investment into four units of Rs 2,500 each.

Each unit can be invested as a separate plan spanning four days in a month. So, for instance, Rs 2,500 each can be invested on the first, fifth, tenth and fifteenth of every month.

It is important to set-up the payments through automated debits or post-dated cheques to ensure that the investor does not abandon the plan during market downturns. Remember, if nothing else, that SIP is about behavioral investing.