What is SIP Investment? How Does it Work?

What is SIP Investment? How Does it Work?: Overview

Stepping into the whole new world of Mutual Funds, the biggest challenge one faces is to how to start investing in Mutual Funds. Investment in Mutual Funds can be either in a lump sum or in regular investments over a period of time, popularly known as SIP or Systematic Investment Plan. SIP has gained a lot of popularity especially with the younger generation and the salaried class.            


How does SIP work?

Even experts warn that it is hard to predict Indian financial markets because one of the major factors characterizing securities markets in developing economies is their volatility. Consequently, there is the inability to predict when the markets will improve or when they will crash. Such volatility leads to investment insecurity, and even astute market watchers lose money just when they expected to gain. That is where the concept of rupee cost averaging enters the scene and SIPs gain popularity.


SIP works on the basic concept of the regularity of investments. It works like a recurring investment of a fixed amount, which gets debited directly from your bank account every month on a predefined date. Thus, SIPs allow you to systematically invest a small amount of money in Mutual Funds every month without your regular intervention. 


Thus, you can invest in Mutual Funds with a small amount of investment every month without hampering your financial liabilities too much. It is an easy-to-understand-and-operate model for most.


What are the Advantages of SIP?

There are quite a few advantages of SIP over Lumpsum as well. To understand the same, you need to first understand the concept of Rupee Cost Averaging and Power of Compounding, along with Discipline and Regularity.

What is Rupee Cost Averaging?

Rupee Cost Averaging is no rocket science. It adopts a very simple and practical principle of being disciplined and regular with investing. Almost each one of us desires to build wealth for future goals. And this is achieved through investing in diverse avenues that generate positive returns. Rupee Cost lets you achieve this goal by being more systematic in your investing, and not in any haphazard way.


Thus, rupee cost averaging refers to the strategy of investing fixed sums at regular intervals, wherein the investment instrument allows the investor to average his/her costs over a period of time—preferably over the long term. Such an investment practice enables investors to use fluctuations in the market to their advantage. The concept involves purchasing fewer units when prices soar and more units when the same prices fall.


The logic is simple enough. Let us say that the net asset value (NAV) of a particular stock is currently Rs. 10 and that the investor invests a certain amount every month. In the first month, the investor will use his monthly investment quota to buy a certain quantity of units (X units). When the NAV rises to Rs. 11 in the second month, the investor will buy fewer units (X units). Then, when the NAV returns to Rs. 10, he will once again buy X units as in the first month.


What this does is that it gives the regular investor an opportunity to accumulate more shares at lower cost than the investor who invests a lump sum once in the year. This kind of staggered investment strategy places less burden on the investor, and the money not yet invested sits secure in the bank earning interest.


To make things clear, let’s take the case of Sachin- a common urban investor.


Given the hectic work schedule, Sachin often faces difficulty in monitoring his investments in stocks and bonds.  His entry or exit from certain stocks is unplanned and staggered- pumping in more cash at wrong times, or missing out on market rallies. He would often wait endlessly for the markets to correct itself. The end result- his portfolio doesn’t seem to be generating very encouraging results.
 

Rupee Cost Averaging- How Does the Technique Work?

An answer to this issue is Rupee Cost Averaging. The concept makes you invest a pre-determined amount regularly, either monthly or quarterly. So instead of making lump sum investment at one go, you make gradual investments, spread out at even intervals, over a period of time.
 

  • Investment at regular intervals
  • Gradual investment rather than a one-time lump sum investment
  • Buy fewer units of the investment when markets are up and more when they are down

Stock and bond prices fluctuate on a day-to-day basis. With the same amount of money invested at regular intervals, your money would buy fewer units of the investment when markets are up and more when they are down. So at the end of the term, the average cost price is considered to determine your gains. Your investment is spread out and risk minimised. This could be explained with the help of an illustration. Consider two options:
 

  • Option 1: a regular investment plan. You invest Rs. 10,000 every month for a period of 6 months.
  • Option 2: a one-time investment plan. You invest Rs.60, 000 at one go.

Option 1

Month

Amount Invested

(A)

NAV of invested plan (B)

No. of units purchased(A/B)

Jan

Rs. 10,000

10

1000

Feb

Rs. 10,000

12

833.34

Mar

Rs. 10,000

10

1000

Apr

Rs. 10,000

10

1000

May

Rs. 10,000

8

1250

Jun

Rs. 10,000

7

1428.57

Total

Rs. 60,000

57

6511.91

 

The average NAV from the above chart would work out to Rs. 9.5(total NAV / number of instalments). The total number of units in holding is 6511.91.


Thus, the fund value at the end of 6 months is: 6511.91 X Rs. 9.5

     = Rs. 61,863.15- a profit of Rs. 1,863.15

Option2:


Now look at the second plan where you invest Rs. 60,000 for 6 months. With the same fluctuation and NAV prices, the cost price at the beginning of the term when units are purchased is at NAV of Rs. 10. Thus, the number of units purchased = Rs. 60,000/ 10= 6000


Fund value at end of 6 months at NAV Rs. 7 = Total units X NAV 
 

                                                                 = 6000 X 7 = Rs. 42,000


We can see that despite a market fluctuation option 1 has generated positive returns. This is because of the averaging effect on the investment.

Benefits of Rupee Cost Averaging

  • Minimizes your risk by letting you invest across market cycles.
  • Makes the most of the market. By investing regularly, you could beat market volatility. You get more units of the investment during market lows and fewer units when market is high. You thus get the average price per unit over time which determines your overall return. 
  • Inculcates the habit of discipline. Investing on a regular basis instills the habit of a planned investment strategy.
  • Eliminates the need to time the market. As you spread your investments out in even time spans, you no longer need to base your investments on market fluctuations. So whether the markets plummet or see a high, you continue this regular investment.

Using SIP for Rupee Cost Averaging

A Systematic Investment Plan (SIP) represents a method of investing money and building a corpus over the long term. Most mutual funds offer investors a SIP facility, which essentially allows investors to put the concept of rupee cost averaging into practice.


SIPs are convenient too. All an investor needs to do is open an online account and schedule investment. The units thus purchased are credited directly to the account. Capital gains on SIP investments are usually taxed on a first-in, first-out basis, and entry and exit loads on such plans are often waived. Moreover, you can start a SIP with as little as Rs. 500 per month. To start investing, click here.


Not only does it eliminate the need to predict the market, it also allows the investor the ease of investing small amounts throughout the year. Because of the staggered nature of payments, the investor does not feel the pinch of investing a lump sum once a year. It seems so much more affordable, thereby increasing investor discipline and encouraging investors to begin investing sooner.


The other major advantage of SIP is Power of Compounding.

What is Power of Compounding?

Life compounded interest accumulates over a period of time, the larger the tenure is the higher the value would be. Thus, an extended investment period always helps one accumulate more wealth due to the Power of Compounding. An early investor accumulates more than one who comes in later.

The below illustrative example demonstrates what Rs. 2000 invested every month accumulates to over a period of 30 years.
 

 

 

Rate Of Interest

No of Years

Amount Invested

6%

8%

10%

15%

20%

5

120,000

160,587

176,319

193,261

241,363

298,598

10

240,000

429,803

518,142

622,498

970,934

1,486,017

15

360,000

862,761

1,141,981

1,503,809

2,929,342

5,546,528

20

480,000

1,539,425

2,237,259

3,229,200

7,855,938

18,402,048

25

560,000

2,403,448

3,835,146

6,067,435

18,434,613

53,421,881

30

640,000

3,675,834

6,440,100

11,167,617

42,375,534

151,920,841

Power of Compounding Technique- How does the Technique Work?

The Power of Compounding is nothing but Compound Interest that we had learnt in childhood. The earlier you invest; you earn interest even on the interest, thus enhancing your investment…simple!!


In Simple Interest, you earn interest only on the Principle invested and in Compound Interest you earn interest on the Principle + Accumulated Interest. If you want to understand how you earn more if you invest earlier, let’s take an example.


Ravi starts saving at the age of 25 years, Rs. 10000 per annum till he is 60 years old. So his Total Savings= Rs. 3,50, 000. Whereas, Raj starts saving at the age of 35 years, Rs. 15,000 per annum till he is 60 years old. So his Total Savings = Rs 3,75, 000.


Assuming a return of 8% p.a. for both, Ravi’s Maturity Value is Rs 17, 23, 168 whereas Raj’s Maturity Value is only Rs 10, 96, 589. So Ravi’s Maturity Value is 57% higher than Raj’s Maturity Value. Thus the longer you remain invested systematically, the more you earn!!

Benefits of Power of Compounding

Other than the obvious benefit of earning over the years, power of compounding is the strongest reason behind Long-Term Savings and Investment. This is basically the reason of starting early to save and continuing it for a longer tenure. In mutual funds, power of compounding plays a huge role, even in Retirement Planning as well as Child Education Planning.


The take away from Power of Compounding is to start early even if the amount is small because the  cumulative returns are so big that it hardly matters how much you start your investments with! The only thing which matters is the tenure of investment!
 

Other benefits of SIP

Other than Rupee Cost Averaging and Power of Compounding there are two more benefits of investing systematically through SIPs like:
 

Regularity of Investments
 

To maintain regularity of investments, SIP is a wonderful tool. Rome was not built in a day and neither will your corpus. To keep building it and growing it systematically might be enhanced by the usage of SIP wherein every month a specific amount of money gets automatically invested in Mutual Funds without your intervention.
 

Convenience


The entire convenience of investing is so powerful with SIP and net banking as well as redemption of units, that the mutual fund investment scenario has quite changed in the last few years or so. You do not need to remember to submit cheques every month and track your NAV and units as the entire process is fully automated.
 

Discipline
 

Along with convenience, it is a hugely disciplined investment with regularity. Thus, the power of compounding and rupee cost averaging works well with disciplinary investments.

Conclusion

Thus, Systematic Investment Plans or SIPs have become an integral part of Mutual Fund Investment. It is however just a process of investment and buying regular units. The benefits and advantages are far and many and hence it has gained popularity.  With transparency and high returns and tax efficiency, mutual funds have become quite popular and helps you in making a robust financial plan for yourself and your family. SIP is thus a wonderful tool which can be used to enhance the portfolio by regular investments.

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