Mutual Fund SIPs are about psychology and not math (the idea is so similar to a chit fund…)

Dhirendra Kumar of Valueresearch usually has great pieces on personal finance and mutual fund matters. The best bit is he always sticks to basics and questions all the jazz which keep coming as hype only to disappear eventually.

In a recent piece, he questions all the noise around Systematic Investment Plans. There are lot of ads showing all the math around SIP:

There are now some six-seven types of SIP available from Indian mutual funds. You can have ‘value-based’ SIPs; SIPs with different periodicities, which claim better returns; SIPs that split monthly instalments into weekly ones; SIPs which claim different dates give better returns; and SIPs that vary your monthly investments according to even more complex formulae.

That’s a lot of choice, and consumer choice is always supposed to be good, right? Well, not quite. I’ll put it bluntly. Having lots of choices in SIPs is an unequivocally bad thing. These choices misguide people as to what the real purpose of SIPs is and how they can succeed at SIP investing.

Worse, they promote the idea that the way to get better returns lies in some newly discovered trick or feature that is available in some SIPs and not in others. This is a bogus idea. The value of an SIP lies in its simplicity.

…..

An SIP is all about investing a fixed sum regularly in an equity fund, regardless of market conditions. Over the long term, you end up buying more units when the markets are down and fewer when the markets are up. Thus, your average purchase price is much likelier to be lower than what it would have been otherwise. Therefore, when the time comes to redeem your investments, they are very likely to be worth more than what they would have been. That’s all there is. There are no guarantees, and there are certainly no fixed formulae of expected returns. ….

However, there is a bigger reason to invest through an SIP. The real value of an SIP is not in maths but in psychology. SIPs are the simplest way of investing regularly and getting good returns from equity, without having to worry about when to invest and when not to invest and thus often missing out on the best opportunities. When the markets turn discouraging, the general instinct of many investors is to stop investing, either because they are scared or because they are trying to catch the bottom. However, SIP investors – not all but most – tend to continue their SIPs. Soon, when the markets go up, this teaches them the value of not stopping their SIPs in bad markets. Thus begins a virtuous cycle, creating a larger new generation of investors who understand the value of regular investing.

This is so true. It is more about psychology than anything else. Much of finance is around psychology as it moves based on so many expectations driven by behavior of so many people. Math is just an effort to add some sanity to the picture but makes it endlessly complicated.

I was thinking about something else. It is interesting how things in finance are interconnected and keep going in circles. What is the history of these SIPs? How did they start and where did the idea come from?

I ask this as the idea for a SIP is hardly new. The chit funds which are a thousand year old financial mechanism, the idea was same. Contribute small amounts regularly just to develop that saving habit. Just that in a MF the proceeds are invested in some securities and one is given units showing the ownership of the stocks. Overtime, the amount invested grows which one can use later for consumption or other things.

In chit funds, one instead bid for the pool to use it for consumption purposes. The securities markets had not developed back then and people needed money higher than their savings. So, this system was devised. It also avoided problem of collateral.

Just like in a MF the fund manager matters, similarly in a chit fund the foreman mattered (there was no case of women running the funds despite their origination in Malabar which had a matrlineal system). The foreman is responsible to collect the funds periodically and investors have to ensure that he does not run away.

So there are these similarities and there are these differences as well. But the idea of using human psychology and save regularly  is the crux behind both. SIP may look and sound modern but similar thoughts started much earlier.

There are a few of these core ideas which keep coming and going back and given new names. One could impart such ideas while teaching finance than the usual math way.

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