What is SIP – Systematic Investment Plan and How it Works?

SIP is a smart tool to invest in Mutual Funds like Recurring Deposit. It works on the principle of regular investments. It is like your recurring deposit in which a small amount is deposited every month. It allows you to invest in a Mutual Funds by making smaller regular periodic investments monthly or quarterly in place of a heavy one-time investment. In SIP you can pay 10 periodic investments of Rs 500 in place of a one-time investment of Rs 5,000 in Mutual Fund. Thus, you can invest in Mutual Funds without altering your other financial liabilities. It is important to understand the concept of rupee cost averaging and the power of compounding to better understands the working of SIPs.

Systematic Investment Plan has brought mutual funds within the reach of an average person as it enables even those with tight budgets to invest Rs 500 or Rs 1,000 on a regular basis in place of making a heavy, one-time investment.

While making small investments through SIP may not seem appealing at first, it enables investors to get into the habit of saving. And over the years, it can really add up and give you handsome returns. A monthly SIP of Rs 1000 at the rate of 9% would grow to Rs 6.69 lakh in 10 years, Rs 17.83 lakh in 30 years and Rs 44.20 lakh in 40 years.

If some one wants to invest in Mutual Funds than SIP is the best way because SIPs reduces the chance of investing at the wrong time and losing sleep over a wrong investment decision. The true benefit of an SIP can be derived by investing at lower levels.

1. Discipline

The rule of building your wealth is to stay focused, invest regularly and maintain discipline in your investing pattern. your monthly disposable income will not be affected by aside a few hundreds every month . You will also find it easier to part with a few hundreds every month, rather than a large sum for investing in one time.

2. Power of Compounding

One must start investing early in life. One of the reasons for doing that is the benefit of compounding. For an example. Hitesh started investing Rs 5,000 per year at the age of 30. When the attains the age of 60, he had built a corpus of Rs 6.12 lakh. If he starts investing the same amount every year at the age of 35, his corpus will only Rs 3.95 lakh. In this example, a rate of return 8% compounded has been assumed. So the difference of Rs 25,000 in amount invested made a difference of more than Rs 2 lakh to their end-corpus. The difference in return is due to the effect of compounding. Return will be as higher with the term.

Now, instead of investing Rs 5,000 every year, suppose some one invests Rs 25,000 after every five years interval, starting at the age of 35. The total amount invested, thus remains the same Rs 1.5 lakh. However, when he is of 60, his corpus will be Rs 5.21 lakh. He will loses the advantage of compounding in early years.

3. Rupee Cost Averaging

It is an investment technique which helps to reduce the impact of volatility on purchases of equity. Rupee Cost averaging is known as pound cost averaging in the UK , dollar cost averaging in the US and unit cost averaging in general.

When you invest the same amount in a fund at regular intervals over time, you buy more units when the price is lower. Thus, you would reduce your average cost per unit over time. This strategy is called ‘rupee cost averaging’.

With a long-term investment approach, rupee cost averaging can smooth out the market’s ups and downs and reduce the risks of volatile market

In a Rupee cost averaging strategy, an investor divides his total planned investment amount into equal amounts , and invests the amount periodically over a certain period . For Example: total planned investment amount Rs 12,000 and invests amount of Rs 1,000 over a period of 12 months.

Rupee Cost Averaging helps to brought down average unit price and minimizes the impact of short term market fluctuations when market going down

  1. As the periodic amount is fixed, one is able to buy more units when prices are low, and hence reduce average buying price.
  2. When one invests regularly, he does need to known when to enter and at what entry price, as long as he is convinced about indicative long term returns. When the markets go up, an investor does not know how high it will go or for how long. So the best approach is to invest the same fixed amount every month.

The technique is called Rupee Cost Averaging as it can potentially reduce the average cost of shares bought in a down market.

4. Flexibility:

It is advisable to continue SIP investments with a long-term perspective, but Investors can discontinue the plan at any time. Can also increase/ decrease the amount being invested.
No entry or exit loads on SIP investments. Applicable Capital gains are taxed on a first-in, first-out basis. If its more than one year it will be treated as long term capital gain

Convenience – SIP is a hassle-free mode of investment. You can issue a standing instruction to your bank to facilitate auto-debits from your bank account.