What are the Risk Factors in SIP?
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Updated date : 08 August 2018
Investing your savings is a great way to ensure long-term financial security and wealth management. Although, with the variety of options available, sometimes it can get confusing how to go about making the right kind of investments. The stock market provides the growth potential but huge risks for those that do not know how to make the identify the right stocks. Also, the stock market can be taxing for an average investor as one needs to regularly monitor changes and accordingly manage the investments, which is why Mutual Funds, offer close to the same kind of investment growth potential without the hassles of regularly managing the portfolio. And with respect to Mutual Funds, there are options like SIP, which stands for Systematic Investment Plans, that help ease the investment. There are many aspects related to Systematic Investment Plans and in this article, we will take you through them in detail.
As a conscious smart investor, one should always have thorough knowledge about the factors associated with any investment. Mutual Funds are based on equity trading which makes them significantly risky if you are considering them to be safe investments. Before we get into the factors and risks associated with mutual funds, let’s understand in more detail what Systematic Investment Plans are?
What are Systematic Investment Plans or SIP?
A Systematic Investment Plan or SIP provides investors with an easy and convenient was to invest money in mutual funds. Instead of having to invest large amounts of money at a given time, the investment plans allow for individuals to set flexible predetermined amounts with a cadence in mind, most often at a monthly interval. Although the cadence is also a flexible factor that can be altered as per the individual's requirements and investment needs. Many Systematic Investment Plans offer, weekly, monthly and quarterly interval periods to keep adding to your investment fund. It allows for future planning in a hassle-free manner that in the long run inculcates a strong habit towards saving and creating financial wealth. The process of investing small amounts on regular intervals into selected equity-based mutual funds is like adding a drop each time towards creating an ocean of wealth. The plans assist in building sound financial investment practices among individuals and aid those who are either limited by low monthly incomes or hesitant from making long-term investments.
Owing to its flexible nature, Systematic Investment plans or SIP, help you set up your investment strategy in a step by step manner. After deciding to avail a SIP, an individual is allowed to choose from a variety of mutual fund offerings. Then you can choose to set the fixed amount that you are willing to invest and the intervals at which you would like to invest these amounts. For example, a person may choose to invest two thousand rupees every month for a period of two years. Having chosen the mutual fund offering in which to invest these amounts, the bank would automatically debit two thousand rupees from the individual’s bank account towards the mutual funds chosen. This process would continue month after month for a period of twenty-four months when the SIP plan would stop. The investment amount would remain in the mutual funds chosen until the individual decides to withdraw his or her investment.
How does the investment work?
Quite often people are confused with how the banks manage their SIP investment money. The banks deduct money from your registered account towards your chosen mutual funds each month on a set date. Mutual funds are broken up into units that are purchasable by investors for a specific price. Since mutual funds are based on equity stock, the prices of these units fluctuate on a daily basis. The bank debits the amount decided by you towards your Systematic Investment Plan and uses the amount to purchases units of the mutual fund you have chosen. Depending on the market rate of individual units of the mutual fund on a particular day, the bank will secure the number of units feasible using the amount you have committed towards your SIP. Therefore, the number of units purchased each month may differ according to the rate. For example, if in month 1, the rate of one unit of a particular mutual fund was ten rupees, and the systematic investment for each month is predetermined to be two thousand rupees. Then the bank would purchase two hundred units for you. In the next month is the price of each unit of the mutual fund rose to fifteen rupees and your SIP amount remains the same, they will then purchase the equivalent number of units feasible, which would be one hundred and thirty-three point three units. This same process would be repeated month after month (or if you have decided on a different time interval period, then according to that cadence).
How does rupee average cost and compounding operate?
With respect to equity, most investors are always careful about finding the right entry point into a market. The reason being that if you enter the market when the stock price is lesser and then the stock price rises, you have already made a profit per unit of a stock that you have invested in. Therefore, finding the right entry point becomes critical towards making profits. The converse is also possible, wherein you may invest in units of a stock and then the price per unit goes lower, you are already at a loss, you’ll now have to wait till the stock rises back up to the cost you purchased at or wait for it to go higher before you decide to sell. In this case, had you waited a while longer, you would have ended up buying units of the stock at a much lower price, which would have been beneficial. Although, when it comes to Systematic Investment plans, the same doesn’t quite apply to you. Since you are regularly investing small amounts into the market, you get to take advantage of the price fluctuations. When the price is lower, you end up owning more units and when the price goes higher, you end up with lesser units bought. In either case, your average cost of the units remains potentially positive. To better understand this point, here is an example. In the first month, one purchased hundred units of a stock at ten rupees per unit. In the next month units of the same stock were valued at fifty rupees and you ended up purchasing only twenty. Now you own a total of one hundred and twenty units with an average purchasing cost of roughly seventeen rupees (total investment divided by the number of units owned). There if the stock remains at fifty rupees per unit, you have already made a profit of roughly thirty-three rupees per unit.
Now, moving over to the compounding factor. Since you are participating in regular investment over fixed intervals, the principal amount keeps growing and the interest accrued keeps getting added to the principal amount. Over a tenure of multiple of ten years, the factors of investment growth can skyrocket. For example, if you are to invest ten thousand every month for a period of ten years at an annual interest rate of twelve per cent (monthly interest rate of zero point nine five), you will earn close to three point four lakhs, with an investment of only one point eight lakhs. Although, if you had invested a sum of seven thousand five hundred for double the tenure at the same interest rates, you will earn close to six point eight lakhs for the same amount invested. Time is a significant factor in increasing the value of your investment using the compounding principles.
What exactly is a mutual fund?
On a side note, we thought of sharing a few details of what mutual funds are exactly and how they work. For most people, the concept of mutual funds seems fraudulent or simply too complicated for them to understand. To many, it is simply intimidating which is why they choose to avoid understanding the basics of it. If you plan on investing using the Systematic Investment Plans or SIPs offered by many financial institutions, you will need to get a fair understanding of what a mutual fund is and how it works. Like the name suggests, it is a fund created by the mutual working of several investors. Each and every one of these investors is focused on the goal to make steady profits from their investment over a period of time. Therefore, the goal of the mutual fund also remains to provide sustainable returns to its investors year after year. In this manner, the money invested by all these investors is pooled towards a fund that is then used to invest in equities, government bonds, securities and several other types of financial market instruments. The fund is managed by a professional fund manager which is usually an investment consulting unit comprised of several individuals, who navigate the Net Asset Value of the fund, also known as NAV. If the fund was worth one hundred rupees, that is its current Net Asset Value. It is the duty of the fund managers to increase this value year after year, so the next year the NAV of the fund should be more than one hundred. For investors, who are a part of this fund, depending on the investment amount, they are allocated units, which are like small bits of the entire fund. If I invested ten rupees in the fund and each unit of the fund is valued at one rupee, I will hold ten units of this fund. When the Net Asset Value of the fund rises from one hundred to one hundred and twenty, the unit price of the mutual fund will also rise to one point two rupees (figuratively speaking). That means that now the ten units of the mutual fund I owned are not worth ten rupees anymore, they are worth twelve rupees, whereby 2 rupees is a profit for the investment I made into the fund.
Now that you understand what Systematic Investment Plans are and how they apply to Mutual Funds, let’s take a look into the risks involved with setting up SIPs.
- Depreciating value of investment:
With the Systematic Investment Plan you are making, there is a monthly deduction of funds from your bank account, which is being utilized towards investment in the mutual funds you choose. Although, since you are unaware of the mutual funds' inner workings and areas in which your investment is circulating, you stand the risk of depreciating the value of your in Over time, your investment might depreciate because the fund is losing money or investing in equity that failed to perform. As a result, you would end up with lesser money in hand than the amount you invested, thereby incurring losses.
- Currency and Foreign investment risks:
Some mutual funds rely on heavy investment in currencies and foreign investments. As long as the currency values go up and the foreign investments remain, there is no cause for con Although, if either fails and in many cases, one could have an effect the other, the entire fund would cave in, resulting in a deficit and possibly no returns or negative returns for you as an investor.
- Liquidity risks:
While you are making investments on a monthly basis, the amount of money you are investing at a time may not be significantly large, although when the time comes to sell the investment and withdraw your funds, you can face the challenge of selling. Low-performing mutual funds are not easy to sell in the market and therefore could result in your investments getting locked in.
- Market and policy changes:
The biggest threat to free market investments are the constantly changing projections and fluctuations in the market value based on political and policy reforms. Drastic changes in either could threaten the goodwill of the market and result in major losses.
- Hidden charges and fraud:
While these are rarely seen in SIPs but there is still the chance of financial fraud. Since you are not managing your fund directly and your investments are passing through many middlemen, there is a possibility that your investment might get duped or you may be cheated out of the profits you earned in the name of hidden charges and other fraudulent practices.
In our fair knowledge, SIPs offer the best modes of investing in mutual funds but due to the nature of mutual funds being risky, the same applies to SIPs as well. Which is why it is a good practice to consult experienced investment consultants before making any investments and also understanding the nature of your investment.
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