Lump-sum Investment in Mutual Funds – What’s the best way?

Lump-sum investments in mutual funds can be tricky.

There are several questions that need to be answered before (and even after!) making a lump-sum investment in mutual funds –

  1. Is the market at right levels for a lump-sum investment in mutual funds?
  2. How to enter the markets? At one-time or via STP?
  3. What is the probability that after 5 years the investment will yield expected return?
  4. How to exit the investments after the investment horizon is over?
  5. What should be the allocation to debt and equity mutual funds?
  6. How to rebalance between debt and equity mutual funds?

Not looking for lump-sum investments? Check out Finpeg Alpha SIP here.

We shall make this blog data intensive to come out with a winning lump-sum investment strategy.

There are 2 popular methods of investing lump-sum amounts in mutual funds

  1. Simple lump-sum

Pick up the amount to be invested from your bank account and dump it all into the equity mutual funds.

In this blog, we are going to talk of facts and figures of 5-year lump-sum investments in NIFTY 50 over the last 20 years.

  1. STP or Systematic Transfer Plan

Park the amount to be invested in low risk funds. Then, switch the amount to equity mutual funds at regular intervals viz. weekly, fortnightly, monthly etc.

STP employs the same principal that an SIP does – cost-averaging.

In this blog, we are going to talk of facts and figures of an STP regime as follows –

  1. Simple lump-sum made in debt funds on the first day
  2. Money from the debt funds is STP’ed in to NIFTY 50 over the next 24 months or 2 years with a monthly frequency
  3. After the deployment has been made in to NIFTY 50, we hold the equity investments over the next 36 months or 3 years
  4. After 5 years from the first day of investment, we redeem the investments in one shot

We shall now see how these two investment strategies – simple lump-sum and cost-averaging – answer the 6 questions posed.

Note We shall use the values of NIFTY 50 of the last 20 odd years for all the analyses

Is the market at right levels for a lump-sum investment in mutual funds?

lump-sum investment mutual funds

This is a question that a simple lump-sum can answer better than STP. Why?

Because whenever you will be investing in mutual funds via simple lump-sum, you will check the market valuation. If indicators like PE ratio, PB ratio etc. look attractive, that would encourage you to invest.

However, who decides what an attractive market valuation looks like? This is something that needs research and expertise. For most average investors, it is not feasible to research their way through ever-fluctuating market levels.

STP, on the other hand, doesn’t answer this question at all. It asks you to start your investment whenever you have money. Once the investment start, market levels or valuations are not due consideration. Highest focus is on efficiently cost averaging your equity mutual funds purchases.

How to enter the markets? Via simple lump-sum or via STP?

Both simple lump-sum and STP answer these questions differently.

Simple lump-sum asks to enter at one go at an attractive valuation (if you can spot one). STP asks you to enter at different valuations and average the purchasing cost of your equity mutual fund units.

Let’s check which method fares better in terms of risk and returns.

lump-sum mutual fund investments
In terms of risk, STP is clearly better. So, cost-averaging does some good but it is at the expense of returns…

Average case return of simple lump-sum is a good 2% points greater than STP’s average return.

What is the probability that after 5 years the investment will yield expected return?

Let’s assume that 12% is the expected return of an average investor for a 5-year period.

Let’s now check what is the probability of earning a 12% return over a 5-year period for both the investment methods.

lump-sum mutual fund investment
You take on equity risk for a long-term period like 5 years and get rewarded for it, at best, only half the number of times.

Both strategies are disappointing in this regard, STP more so.

How to exit the investments after the investment horizon is over?

This is interesting! Neither investment method has an exit plan.

How do you exit? Based on cash requirement? Based on market valuations? Based on a something else altogether? Who knows!

Finpeg Lump-sum Investment Strategy answers this question comprehensively as we see in some time.

What should be the allocation to debt and equity mutual funds?

lump-sum investment mutual funds

Simple lump-sum says that you should invest in equity mutual funds on day 1 and stay invested until you wish to redeem. That doesn’t sound like a good plan, does it?

Let’s say you started investing in January 2004 and had a 5-year investment horizon. Let’s what would have happened had your money if the investment was made in the NIFTY 50 index.

Depending up on which date in January you started your 5-year investment, your returns would have been anywhere between 7% and 10%.

That’s not desirable at all! You invested for the most part of the finest bull phase the Indian Capital Market has ever seen and come out with a return that’s about the same as the FD rates prevalent then!

Of course, this is one of the worst cases that we are looking at. But shouldn’t the whole point be investing in an investment strategy that is absolutely fool-proof?

Why should one have to check out which strategy comes out on top at different scenarios? It would be simple to crack the code once and for all and stick to it!

How to rebalance between debt and equity mutual funds?

Another a question that isn’t answered by either investment methods.

STP is just a deployment strategy. It invests money from safe, low-risk funds into equity funds at regular intervals. It doesn’t allow for the reverse journey at any point in time.

Simple lump-sum investment strategy is no different. It tells you when to invest in equity mutual funds. So, from day 1 of investments until the time you redeem you are at 100% equity. And we just saw a few paragraphs earlier how bad things could go if you are 100% equity always.

So, what should be a rebalancing strategy? Should it strive to maintain a constant debt to equity ratio? Should you switch between debt and equity basis the market levels/valuations? Who knows!

Let’s say you did come up with a killer rebalancing strategy. What next? How would you execute it? Manually?

Let’s have a look at an investment approach devised at Finpeg. We refer to it as Finpeg Lump-sum Investment Strategy and here’s how it works…

Finpeg Lump-sum Investment Strategy

You should be neither at a pre-determined debt to equity level (like an STP) nor should you always be at 100% equity (like simple lump-sum)

At Finpeg, we believe an active management is highly beneficial to extract the most out of your mutual fund investments. Active management here refers to making changes to your portfolio’s debt and equity allocations. These changes are made as the market conditions change.

Logically, you should stick to debt instruments if the markets are near higher valuations. This is because, as we shall see, as the market valuation approached historically high valuations, the probability of a market correction starts increasing.

On the other hand, as the market valuation drops, you should be encouraged to invest equity mutual funds. This is because as the market valuation drops, the probability of a market rally or a bull phase starts increasing.

This can also be validated by observing the following –

lump-sum mutual fund

If you see closely, the PE ratio has always dropped from high levels like 28 – a level that we have been very close to for the last few months. Whenever this happens, there have been market corrections and recessions. So, a PE ratio of 25-28 is the least suitable to invest into equity mutual funds.

On the other hand, lower PE ratios like 14-16 should encourage you to take an increased exposure to equity mutual funds.

There are multiple indicators that give you a sense of market valuation. We had a look at the PE level’s behaviour.

We can also have a look at the PB ratio’s behaviour, the market cap-GDP ratio’s behaviour etc. And all of them shall have a story to tell. All these stories can be put to good use which is exactly what we have done at Finpeg!

The sophistication we have put into Finpeg Lump-sum Investment Strategy is immense and unprecedented. If you are looking to invest in mutual funds in a lump-sum manner and are intrigued by our investment algorithms, you can get in touch with us here.

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