You may have heard this from almost every relationship manager, wealth manager, mutual fund agents, etc that the best way to invest in these volatile times is via SIPs. I have come across a couple who couldn’t even let me know the full form of SIP but were very well chanting upon the benefits of SIP and the glorious investment methodology it follows. Some white collar advisors used complicated terminologies to sound SIPs as one of the best investment tool invented by them. However, what exactly is SIP?
What is SIP?
SIP stands for Systematic Investment Plan. As the full form entails, it requires a person to be systematically investing into any asset product, such as equity, gold, debt, fixed deposits or even land. However, it has been more commonly used for investing towards investing into Mutual Funds. You may want to refer to our article What is a Mutual Fund to get more understanding on this financial instrument. SIP requires a person to invest on a regular basis (can be monthly, quarterly or half yearly) into a mutual fund and hence enforcing a disciplined approach towards investing. Hence you may note that it is not a rocket science. It just forces a person to be disciplined and be regular with their investment, a thing which is most commonly ignored.
The oldest and most common form of investing via SIP has been investing into LIC / Insurance policies which required a person to pay yearly insurance premium for several years and after that reap the maturity proceeds. However, the disadvantage of investing into LIC / Insurance policies were lack of flexibility to discontinue the payment of insurance premiums and hence a person was forced to invest regularly for several years (10-20 years) till maturity. Another commonly heard product is Recurring Fixed Deposits or RDs where a person makes a regular investment with a bank or a post office and gets the lumpsom amount with interest at maturity.
So what exactly SIP achieves ?
To explain this question, lets take one asset class which most of you would be most comfortable with (specially ladies) – GOLD. It has been passed on from generations that Gold as an investment asset class is one of the least risky or rather risk free investment. If we look into past 10 years, gold has been increasing from around Rs. 5000 per 10 gram to around Rs. 25,000 per 10 gram which around 5 times over the period of 10 years. Not that I am suggesting that this kind of growth would continue in future, however there were times where the gold prices didn’t move at all, rather they experienced a negative return. Only the investors who invested with a long term outlook would have benefited the most out of this bull run of gold prices.
Now how would SIP in Gold work ? Consider that every month you would like to invest Rs. 10,000 in Gold, irrespective of the price of gold. The pattern over the next 12 months may look something like this:
|Month||Monthly Investment||Gold price||Grams Purchased||Total Grams Purchased||Total Investment||Cost Per Gm||Value of Gold||Profit / Loss|
The prices are hypothetical to explain the concept of SIP in Gold.
To explain the above table, if you invested a monthly amount of Rs. 10,000 over a period of 12 months, you would have invested a total of Rs. 120,000. Each month, at the prevailing rate of Gold (in our example, Rs. 5,000 / gm, Rs. 5,200/ gm and so on), a specific grams of gold would be purchased (Column D). Hence, due to monthly fluctuations in the price of gold, you would purchase different grams of gold for the same Rs. 10,000 investment amount. Over a period of 12 months, you would have purchased a cumulative 24.08 grams of gold which at the closing price of 12th month would be valued at Rs. 131, 249. You would be gaining Rs. 11,249 over your intial investment of Rs. 1,20,000. You may notice that while during the course of 12 months, for months 3 to 6, you would be having notional losses, however owing to the consistent investment approach, you would be averaging down the cost of your gold (per gram). Since over a long term, gold prices would be heading north, you would stand to gain from the gold purchased at lower prices.
If SIPs are that simple, why don’t every one become rich ?
This is an excellent question with a very simple response. There is a common saying while investing into stock markets – When every one is greedy, be fearful and when every one is fearful, be greedy. What it means is that when every one is very bullish about the stock markets, it is a time to become conservative and vice-versa. However, even after knowing this time tested theory, people tend to doubt its relevance when there is blood on the stock markets. In these testing times, every one tries to seek for shelter in fixed income products such as fixed deposits which would provide a specific return for your money and would keep your capital safe. However, the thing which gets forgotten is that fixed deposits would keep the capital safe, but won’t provide growth to the capital.
Hence in testing times, people loose their patience, stop buying into the stock markets or rather sell their existing stock / mutual fund holdings and thus loose their opportunity to enhance their long term returns.
So how should I proceed with SIP ?
The following steps may be followed to be a successful investor in SIP:
1. The first and foremost, contact your financial advisor to arrive at an amount which you should invest into SIPs. Avoid contacting mutual fund agents who may find it lucrative for you to invest as much as possible into the SIPs as it would provide them more commission income. The SIP amount should be selected based upon your monthly savings and long, mid & short term liabilities. A too large SIP amount would make it very difficult for you to meet the monthly commitment, eventually force you to stop your monthly SIPs and hence defeating the overall purpose. On the contrary, a too small SIP amount won’t achieve your future goals. It is very possible for initial investors to invest too little as they don’t understand the product and hence reduce their future growth opportunities;
2. Select a right mutual fund scheme to invest your SIPs into. The schemes should be intelligently selected to provide you a good combination of diversified, sector specific (such as Banking, Infrastructure), asset specific (such as Gold) and market capitalisation (such as Large cap, mid cap and small cap stocks) exposure. A right scheme would go a long way in enhancing your returns in future.
3. Make sure that you fund your bank account regularly to avoid your SIPs from bouncing. This is the simplest and the most ignored aspect. Generally the bank balance from where the SIPs are deducted reach a zero and the investor forgets to replenish the bank account for the funds required for SIP. Either you or your financial advisor should monitor your SIPs to ensure that they don’t bounce due to this issue.
Advantages of SIP
One of the biggest advantage of SIP is its simplicity and flexibility. To enumerate them in a bit more detail, the advantages are:
1. SIPs in mutual fund can start with an amount as little as Rs. 500. Hence you don’t need to have a big bank balance to start your investments.
2. You can at any time increase your monthly SIP amount, reduce it or stop it. For example, you can initially start with a SIP of Rs. 5,000 per month and when your financial cash flows improve, you can increase it to Rs. 15,000 per month. If your financial cash flows deteriorate , you can reduce the SIP amount to Rs. 7500 per month.
3. You can encash your SIPs at any time and hence it provides a high level of liquidity to your investment. While being a big advantage, this acts as a biggest risk to your future savings as well as it would not prevent a person from using it as a regular source of funding for their short term expenses.
4. SIPs in equity mutual funds is tax efficient. As per the current tax laws, entire capital gain on Equity mutual fund SIPs is tax free. For example, if you invested Rs. 10 lacs over a period of 10 years and it is valued after 10 years at Rs. 1 crore, the entire capital gain is tax free as per the current laws.
5. Slowly and steadily, SIPs help you in saving a considerable amount of funds for your long term requirements. Since they are done on a monthly basis, it inculcates a disciplined approach towards investments and gets incorporated in your monthly budget.
You might also want to understand the tax impact of mutual funds which is discussed in great detail on our other article Tax Impact of Mutual Funds on Residents & NRIs.
If you need any further details on how to invest or start your investments via SIP, please feel free to contact us. Our details can be found on our website www.banyanfa.com .
9 Replies to “How SIPs Work”
You did not point out the disadvantages of SIP. In rising market SIP will not work. it is worth mentioning.
You have raised an interesting point here. However considering the volatility of the stock markets, it is more advisable to go via a SIP. In long term markets would tend to go north and hence even in a bull market you would make money out of SIP as the value of each purchase would increase with the stock markets going higher.
[…] The human intervention to place an order each time you want to buy Gold ETF adds a physcological resistances. For example, if the gold prices are ruling at Rs. 2600 per gram, you may want to wait for the prices to come down by a couple of hundred rupees to invest into it. When it comes down to Rs. 2400, you may wonder that the prices may correct further. Finally the prices take a U turn and reach Rs. 2800 and then you wonder why didn’t you buy them at Rs. 2400 levels ! To avoid such resistances, a simple and effective investment tool called Systematic Investment Plans (SIP) are offered by mutual fund houses to invest regularly into mutual funds. For details on SIPs have a read of our article How SIPs Work. […]
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