What is SIP (Systematic Investment Plan) – How Does SIP Work?

What is SIP?

An SIP (Systematic Investment Plan) is an ideal way of investing in the mutual funds. It allows the investor to invest in regular intervals. It is a planned way of investing, which helps cultivate the habit of savings and accomplish the goal of wealth generation.

Under SIP, one can invest on a quarterly, monthly or weekly basis as per their convenience. A fixed amount is auto-debited from the policyholder’s account and invested in mutual funds. A pre-decided number of units are allocated at the current market price. Since these plans are flexible in nature, the investors can increase the amount or discontinue investing in the plan whenever they wish to.

Why Should I Invest in SIP?

Let’s take an example of a common man. Ravi, a 32 year old accountant lives in a rented house with her lovely wife and a 4 year old daughter. His primary financial goals for the next 20 years are, to buy a car and a house and get his daughter married. He does invest in bonds but that is it.

When projected into the future, his savings (yielded from bonds) will not be enough to suffice his future expenses and he’ll fall short of achieving his goals. This will primarily be due to 2 reasons:

• The bitter fact that the inflation will grow faster than the returns, eventually dwarfing his savings at the end of the investment tenure.
• Had he invested in equity instruments rather than bonds, he could have earned a higher return.

Ravi justifies his investing in bonds as he believes in playing it safe. So the question remains intact, what should he do to achieve a substantial growth without getting affected by the turbulence of the market. Well, the only way Ravi can achieve his financial goal is buying a Systematic Investment Plan.

And it’s a good enough reason for you too, to get a SIP Investment.

How to Get Started with SIP Investment?

When it comes to SIP, getting prepared is as important as playing the game itself. You need to follow 4 easy steps before you actually start investing in SIP.

• Set your financial goals – Your goals should be specific and attainable.
• Set a timeline – Decide when you need the money; this will be your investment tenure.
• Decide how much you need to invest – With the help of a SIP calculator, figure out the amount you need to invest regularly to accomplish your financial goals.
• Make a choice – Consult your financial advisor and go for a plan that meets your needs well.

Now you are all set to go. The money can be paid by post-dated cheques or through ECS (Electronic Clearing Service) in which you give a standing instruction to your bank to auto debit the investment amount from your account every month. The sum that you invest every month in the chosen SIP is invested in a mutual fund and makes money for you. You can always log on the company’s website and track your portfolio.

How does SIP work?

Systematic Investment Plan(SIP) works more or less like a mutual fund. The handling of your money is done by money market experts and is none of your headache. But it is good to know how SIP makes your money grow. Well, there are two underlying mechanisms behind the working of SIP.

Effect of Compounding

Unlike simple interest, the compounding involves making the interest earned, a part of your base capital and the subsequent interest is calculated on the basis of this new increased capital. Thus, Compound Interest leads to an exponential growth of your money. The effect of compounding increases as the investment tenure increases. The table below illustrates the fact.

As can be seen, there is a 7% rise in the total output when the interest is calculated on a compounding basis. This seemingly small difference in the final output becomes staggering as the period of investment lengthens. The table below shows the figures when calculated for a period of 20 years. As you can see, the difference becomes even more than twice in the long run, when the effect of compounding is playing up.

Rupee Cost Averaging

Consider a scenario – Gaurav decides to invest in a SIP and buy the market units by investing Rs 1000 per month for 6 months. Obviously, he’ll be bagging more units when NAV is low and lesser units when NAV is high. On the other hand, Rashmi makes a one time investment by buying units for Rs 6000 at the current NAV. Who do you think is going to end up with a lower cost per unit at the end of the 6 months period?

As can be seen from the table above, Gaurav will be enjoying a gain of Rs 2.58 per unit over Rashmi. Gaurav played up smart by investing consistently for a period of time. In the long run he’ll be less and less affected by the ups and downs of market, as the time period will lead to an averaging of the market fluctuations. This effect is called as Rupee Cost Averaging and is primarily responsible for making SIP a lucrative investment.

Perks of SIP

• Flexible and affordable investment options – You can always start with smaller amounts and increase the sum of investment as your earning grows with time.
• Free of entry or exit charges – If you invested in SIP and discovered that it doesn’t work well for you, you can put a brake to making further investments and withdraw every single penny without incurring a penalty.
• Saves you time – By opting for ECS, you drive handsfree. You can go to your own business while your money takes care of itself.
• Keeps you stress free – Unlike a mutual fund, you are free of the tension stemming from the ups and lows of market.
• Saves you overloading your head – You need not to have a know-how of the market or the tactics that go into switching between funds. It is all done for you by the money market experts.

Keep in Mind

• Start early, earn bigger returns
• Stay longer, enjoy the compounding effect
• Be patient, the money is sure to grow in the long run
• Be consistent, never skip your monthly payment

Like the hare-tortoise story, the success mantra in SIP besets, not in how fast you run but how long you run. Here the race is won by starting early and staying longer.