What Is SIP Investment And How Does SIP Work?

Investing generally seems daunting. But everyone wants to grow their wealth over a period of time, isn’t it? That’s where a Systematic Investment Plan (commonly known as SIP) helps us. This guide will explain what SIP is, how it works, and what its advantages are, with a focus on the Indian market.

What is Systematic Investment Plan (SIP)?

A systematic investment plan is a scheme where a person can invest a small amount of money at regular intervals over a long period of time in a mutual fund scheme. The amount chosen by the investor is automatically deducted from their bank account and invested in a selected mutual fund. This method is helpful in building disciplined investment habits and is beneficial for individuals with limited investable surplus.

How does an SIP Work?

SIP automates the investment process. It doesn’t require decision-making each and every time a person invests. When you start a SIP, a fixed amount is directly deducted from your bank account at regular intervals (typically monthly) and invested in your chosen mutual fund.

The following are some of the key financial and economic principles on which SIPs work:

1. Rupee Cost Averaging

Rupee cost averaging helps to manage the ups and downs of the market. For example, you decide to invest Rs. 1000 every month in a mutual fund. When the market prices are high, your Rs. 1000 buys fewer units of the mutual fund. When the prices are low, your Rs. 1000 buys fewer units of the mutual fund. When the prices are low, the same Rs. 1000 buys more units. Over a period of time, this method averages out the cost of the units you buy, so you don’t have to worry about trying to “time the market” – buying low and selling high – which is very difficult to do consistently.

Example:

-   January: Rs. 1000 buys 10 units at Rs. 100 each.

-   February: Rs. 1000 buys 12 units at Rs. 83 each.

-   March: Rs. 1000 buys 8 units at Rs. 125 each.

So, by the end of three months, you have invested Rs. 3000 and own 30 units. The average cost per unit is Rs. 100, even though the market prices fluctuated.

2. Power of Compounding

There’s a reason why renowned scientist and Nobel Laureate Albert Einstein described compound interest as the eighth wonder of the world!

Compounding is like earning interest on your interest.

When you invest money, you earn returns on it. If you further invest those returns, they start earning returns too. Over a period of time, this can significantly affect the value of your investment. For example – You invest Rs. 1000 every month, which gives an annual return of 12%. In the first month, you invest Rs. 1000. In the second month, you invest another Rs. 1000, but now the first month’s investment has also grown by 1% (approximately Rs. 10). This process keeps repeating, and over many years, these returns start generating their own returns, significantly increasing your investment.

Imagine two friends, Ramesh and Suresh, who both decide to start investing Rs. 1,000 per month in a SIP at an annual return rate of 7%. Ramesh starts at age 40, while Suresh starts at age 20. By the time they both reach 60, Ramesh will have accumulated around Rs. 5.28 lakh over 20 years, while Suresh, who invested for 40 years, will have around Rs. 26.56 lakh. The earlier you start, the more your money grows exponentially over time.

Benefits of SIP Investment:

1. Financial Discipline

SIP instils a disciplined approach to investing. The regularity of contributions ensures that you save and invest consistently, which can be particularly beneficial for achieving long-term financial goals such as retirement or higher education for children.

2. Flexibility and Convenience

SIPs are highly flexible. You can start with an amount as low as Rs. 500 per month and increase it as your income grows. Moreover, you can choose the frequency of your investment, which may be monthly, quarterly, etc. Many mutual funds also offer the option to pause or stop SIPs without any penalties.

3. Affordable Investing

For many investors, making a large one-time investment is challenging. SIP allows you to start with a small amount, making it easier to begin investing and build a steady portfolio over time.

4. Low Minimum Investment

Most SIPs in India allow you to start with a minimum investment of Rs. 500 per month. This low entry point makes it accessible to a wide range of investors.

5. Compounding Investments

The returns generated from SIP investments are reinvested, leading to the compounding effect. Over a long period, this can significantly increase the value of your investment.

Types of SIP:

1. Fixed SIP

In a fixed SIP, the investment amount will be constant throughout the duration of the SIP. It is the most common type, and it is suitable for investors with a steady income who want a simple, disciplined way to invest regularly without changing the amount.

2. Top-Up SIP

A Top-Up SIP allows you to increase your investment amount periodically. For instance, you might start with Rs. 1000 per month and decide to increase it by Rs. 500 every year. This helps you to invest more as your income grows.

3. Flexible SIP

A flexible SIP, as the name suggests, has no fixed amount or strict schedule. You can change the amount and frequency based on your financial situation. If you have extra money, you can invest more; if you’re short on cash, you can invest less or even skip a payment.

4. Perpetual SIP

A perpetual SIP does not have a fixed end date. It keeps investing your money regularly for a long-term goal, such as a retirement plan or wealth creation, and there is no predetermined date to stop the SIP unless you choose to end it.

Factors to consider before starting an SIP:

1. Investment Goals

Identify your financial goals and determine a time frame to achieve them. Whether it’s for retirement, a child’s education or for buying a house, knowing your objectives will help you choose the right SIP.

2. Risk Appetite

Understand your risk appetite. Generally, equity mutual funds offer higher returns but come with greater risk, while debt funds are safer but provide comparatively lower returns. Choose a SIP that aligns with your risk profile.

3. Fund Performance

Before selecting a mutual fund scheme for SIP, look at its historical performance, the fund manager’s track record, and the scheme’s investment plan. A consistent performer over a period of time is usually a safer bet.

4. Expenses

Be aware of the associated costs, such as expense ratios, transaction fees, and exit loads. These expenses can impact your overall returns, so choose funds with lower fees.

Common Misconceptions about SIP:

1. SIP Guarantees High Returns

While SIPs are designed to reduce risk and potentially offer better returns over time, they do not guarantee high returns. The returns of your SIP depend on the underlying mutual fund’s performance, which is subject to market risks.

2. SIP Is Only For Small Investors

SIPs are suitable for all types of investors, irrespective of the investment amount. Whether you invest Rs. 500 or Rs. 50,000 monthly, the benefits of SIP remain the same.

3. Stopping SIP During Market Downturns

Many investors panic and stop their SIPs during market downturns. However, this is the time when you can buy more units at a lower price, which can be beneficial in the long run due to rupee cost averaging.

Conclusion

Investing in a Systematic Investment Plan (SIP) is an effective and disciplined way to build wealth over time, making it accessible even to those with modest financial resources. By understanding and leveraging the principles of rupee cost averaging and the power of compounding, investors can navigate market volatility and maximise their returns. It is accessible to investors of all types with different risk tolerances and can be tailored to meet individual financial goals. By understanding how SIP works and its advantages, you can make informed decisions to achieve your long-term financial objectives.