What is SIP and How Does It Work?

The full form of SIP is a Systematic Investment Plan. SIP is an investment strategy offered by different mutual fund houses to investors. It is a convenient process of investment wherein the investors can invest a fixed sum of money regularly in their mutual funds. The investment can be made on a quarterly, monthly, or weekly basis.

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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, the investors can increase the amount or discontinue investing in the plan whenever they wish to.

Why Should I Invest in SIP?

As SIP full form is systematic investment plan. it literally means the same. Let’s take an example of a common man Ravi. 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 will fall short of achieving his goals. This will primarily be due to 2 reasons:

  • The bitter fact is that 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: What should he do to achieve substantial growth without getting affected by the turbulence? Well, the only way Ravi can achieve his financial goal is by buying a Systematic Investment Plan.

And it’s a good enough reason for you to get a financial goal: buying a Systematic Investment Plan.

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 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.

After following these simple steps, 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 account to auto-debit the investment amount from your account every month. The sum you invest monthly in the chosen SIP is invested in a mutual fund and makes money for you. You can always log on to the company’s website and track your portfolio.

*All savings are provided by the insurer as per the IRDAI approved insurance plan. Standard T&C Apply

How Does SIP Work?

SIP's full form is a Systematic Investment Plan and it works more or less like a mutual fund scheme. Money handling is done by money market experts and is none of your headaches. 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, compounding involves making the interest earned a part of your base capital, and the subsequent interest is calculated based on this newly increased capital. Therefore, compound interest leads to an exponential growth of your money. The effect of compounding increases as the investment tenure increases. The table below illustrates this fact:

  SIP Investment Input (Rs) SIP Investment Tenure Rate of Interest Returns (at the end of the tenure) (Rs) Total Output (Rs)
Simple Interest 100 5 years 0.1 50 150
Compound Interest 100 5 years 0.1 61 161

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 calculated for 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.

  SIP Investment Input (Rs) SIP Investment Tenure Rate of Interest Returns (at the end of the tenure) (Rs) Total Output (Rs)
Simple Interest 100 20 years 10% 200 300
Compound Interest 100 20 years 10% 573 673

Rupee Cost Averaging

Consider a scenario – Gaurav decides to invest in a SIP and buys the market units by investing Rs.1000 per month for 6 months. He will 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?

Month NAV (Rs) The monthly investment made in SIP (Rs) No. of Units Average Cost Per Unit One Time Investment made in a plain Mutual Fund (Rs) No. of Units Average Cost Per Unit
1st 15 1000 67

12.42 Rs/Unit

6000 400

15 Rs/Unit

2nd 12 1000 83 - -
3rd 10 1000 100 - -
4th 12 1000 83 - -
5th 15 1000 67 - -
6th 12 1000 83 - -
Total   6000 483 - -

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 some time. In the long run, he’ll be less and less affected by the ups and downs of the market, as the period will lead to an averaging of market fluctuations. This effect is called Rupee Cost Averaging and is primarily responsible for making SIP a lucrative investment

*All savings are provided by the insurer as per the IRDAI approved insurance plan. Standard T&C Apply

Perks of Systematic Investment Plan (SIP)

  • Flexible and affordable investment options – You can always start with smaller amounts and increase the sum of your investment as your earnings grow 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 on making further investments and withdraw every single penny without incurring a penalty.

  • Saves you time – By opting for ECS, you drive hands-free. 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 the market.

  • Saves you from overloading your head – You need not have a know-how of the market or the tactics that go into switching between funds. It is all done for you by money market experts.

Keep in Mind

  • Start early, earn more significant 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 is not derived from how fast you run but is based on how long you run. Here the race is won by starting early and staying longer.

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