The law of demand clearly states that at higher prices demand is less and vice versa. The retail investor investing in the stock market doesn't quite follow that logic.
Most retail investors tend to invest when the markets are nearing their peak and tend to get out once the market starts falling.
Lately, even those investors who invest through the systematic investment plan route have been stopping their SIPs once the stock market starts falling.
This goes against the entire purpose of investing in an SIP. Let's take the case of an investor who invests Rs 75,000 in the Reliance Growth Fund on May 1, 2006, just before the Sensex reached the then peak of 12,612.38 on May 10, 2006. After that the market crashed reaching a low of 8,929.44 on June 14, 2006.
This individual could not face the crash and did not invest in the market after that. Having said that, he continued to hold onto the investment he had made. The value of his investment as on July 31, 2007 stood at Rs 96,589.91. By deciding not to invest when the market was not doing well, this individual missed out on the rally that followed.
On the other hand let us take the case of another individual who invests Rs 5,000 every month through the systematic investment plan route in the same scheme. By investing Rs 5,000 every month over a period of fifteen months, he has invested Rs 75,000 in the scheme.
As on July 31, 2007, the total value of his holdings stood at Rs 98,414.06. This investor does not stop his SIP when the markets are not doing well and continues to invest and ends up a little better than the investor who invests at a single go.
Let us take the case of another pair of investors. One invests Rs 75,000 in the SBI Magnum Contra Fund on May 1, 2006. The other does an SIP of Rs 5,000 every month in the same scheme. As on July 31, 2007, the value of the former's investment is Rs 91837.16 whereas the value of the latter's investment is Rs 94958.70 . In this case, the individual, who follows the SIP route, ends up with more than Rs 3,000 greater.
The point to remember here is that investing through the SIP route brings rupee cost averaging into play. Rupee cost averaging ensures that investors limit their purchases when the markets are doing well and buy more when the markets are not doing well.
But this will only happen if the investors continue to invest when the markets are not doing well. If they stop making investments when the markets are not doing well, rupee cost averaging does not come into play.
Another point that investors should remember is that the concept of SIP works only because stock markets are volatile. If they just kept going up, without ever falling, then the investor would obviously be better placed, by investing all the money that he has at one go. But that clearly is not the case. Markets go up, markets go down and that is what makes the concept of SIP work.
Also, the quintessential principle of investing is to buy low and sell high. But most individual investors decide to enter the markets only when the markets are doing well and hence go against the principle. Rupee cost averaging automatically ensures that investors follow this principle.