What is SIP Investment: How does it Work?

What is SIP in mutual funds?

A systematic investment plan or SIP is a method of investing in mutual funds where an investor opts for a mutual fund scheme and invests in it at fixed intervals. An SIP investment plan works by investing a small amount of money over time rather than investing a one-time huge amount that could result in higher returns.

How does a SIP work?

Once you opt into a systematic investment plan, the amount will be automatically debited from your bank account and reinvested in a mutual fund that you purchase at some predetermined time interval. By the end of the day, you will be allocated units of your mutual fund that depend on its net asset value.

With every investment into an SIP plan in India, any additional units will be added into your account as per the market rate. With every investment that is made, the amount that you reinvest will be larger in addition to any of the returns that you see on those investments. The investor decides whether or not to receive the returns at the end of the SIP’s tenure or at any periodic intervals. Let’s try to understand this better using an example.

Assume that you want to invest in a mutual fund of your choice. Accordingly, you set aside a sum of ₹1 lakhs to invest in the same. There are two ways in which you can choose to make this investment. You can either make a one time payment of ₹1 lakhs in the mutual fund of your choice, which is known as a lump sum investment. Alternatively, you can choose to invest using an SIP. The steps will be as follows:

  • • Begin by setting the amount you wish to invest via your SIP each month. Let’s assume you choose ₹500.
  • • Following this, ₹500 will be deducted from your account each month, and automatically credited into the mutual fund that you want to invest in at a certain fixed date every month.
  • • This process will continue for the duration that you have selected for your systematic investment plan.

Types of Systematic Investment Plans:

Below are the different kinds of systematic investment plans you can consider investing in:

Top-up SIP:

This kind of systematic investment plan enables you to increase your investment amount on a periodic basis while also giving you the flexibility to invest more when you have a higher income that can be invested. This type of SIP also helps one make the most out of their investments by investing in the best as well as the most high performing funds at regular intervals.

Flexible SIP:

As suggested from its name, this type of systematic investment plan carries with it the flexibility of the amount you want to invest in. The amount that is to be invested as per an investor’s cash flow and needs or preferences can be increased or decreased.

Perpetual SIP:

This type of SIP Plan enables you to carry out your investments without any end to the mandate date. Generally, a systematic investment plan carries an end date after one year, three years, or five years of investing. Hence, the investor has the freedom to withdraw the amount that is invested whether or not he wishes to invest in accordance with his financial goals.

Benefits of SIP investing:

Here are some of the several benefits when it comes to investing in an SIP over a lump sum investment. Some of them are listed below.

Makes you a more disciplined investor:

In case you do not possess superior financial knowledge about the way in which the way the market moves, an SIP can make the ideal investment option. You need not spend your time analyzing market movements to find the right time to invest in something. With an SIP, your money is automatically deducted from your linked bank account and it goes towards your mutual funds.

Rupee cost averaging:

One of the main advantages of SIPs is rupee cost averaging. Since the amount you invest remains constant for a longer time period, with rupee cost averaging you can make the most of market volatility. The fixed amount that you choose to invest implies that your SIP will average out the value of each unit. Hence, you can choose to buy more units once the market is low and opt for lesser units when the markets are high. Ultimately, this will lower your average cost per unit.

Power Of Compounding:

SIPs allow the small amount you invest on a daily basis to grow into a large corpus as a sum of your contribution with returns that have compounded over the years. The power of compounding without the hassle of having to invest a lump sum amount gives SIPs a unique advantage over standard investment options.

How to Choose a Good Mutual Fund for SIP?

The answer to this question lies in identifying why you are investing and what the goal is. Say you have a long-term goal such as preparing for your child’s higher education, marriage, or a dream home, you would need to choose a mutual fund SIP that allows you to invest over the long term. A SIP to fulfill goals such as getting a home renovation done or going on a vacation would be one that offers a short-term investment horizon.

You could also look at  the fund’s expense ratio before you opt for a SIP. The expense ratio is annual charges in percentage that are needed to manage or operate your investment portfolio. This can vary from fund to fund with ceilings mandated by SEBI for equity and debt schemes, and on the basis of net assets. 

It is important to look at the fund philosophy, investment horizon and your own goals while choosing a good mutual fund for SIP investment. Also, rather than focusing on a nice mutual fund for SIP, focus on what fund is in line with your investment principles and timeframe. There is no best, there is only what is best for you, and no two people pick the same fund. 

Types of Frequencies for an SIP

types of SIP frequencie

Points you must consider while selecting your SIP frequency

Monthly SIP, quarterly SIP, weekly SIP or daily SIP – you may be a little confused about the interval of SIPs you should opt for. You can decide it based on your income, expenses, ongoing EMIs, scheme you are investing in, financial goals, etc. However, you must ponder upon the following factors and their effect on the SIP frequency while deciding how often you want to invest in a particular SIP.

1. Effect of volatility

Depending on the volatility of the investment avenue, you should decide on the frequency of your SIP. If the volatility of the mutual fund or stock SIP is higher, you can invest in a higher frequency SIP so as to benefit from the market volatility by averaging out your investment over a period of time and vice-e-versa.

2. Frequency of your cash inflows

If you are a salaried professional and earn income on a monthly basis, it is advisable to invest in a monthly SIP. However, if you work on a contract basis where you receive income every few months (for example – construction business, interior designing, etc.) you can choose to invest in a SIP on a quarterly basis. You can plan to invest in weekly SIPs when you earn on a fortnight or a weekly basis (for example – internship, task-completion basis, etc.)

3. Ease in tracking installment payments

It is easier to track your incomes and expenses monthly and thus, investment can be planned better on a monthly basis. You won’t have to keep track of how much was debited throughout the month as the installment amount will be debited once every month. On the other hand, in case of daily and weekly SIPs, the number of installments is higher leading to difficulty in keeping track of all the payments.

Common Myths about SIPs:

Not for Large Investors:

There is a common misconception that SIP plans are only for small investors. However SIP has got more to do with the frequency of payments rather than the total amount. Anybody can invest in a SIP plan, and up to Rs. 1 lakh can be invested provided your KYC process has been completed.

Don’t Invest in SIP When Market is Bullish:

A bullish run occurs when the market is showing an upward trend, and many myths suggest that you must not invest in SIP when the market is being bullish. However, this is a baseless myth since an SIP relies on the rupee cost averaging to guarantee investors their returns and the rupee cost averaging works well over the long-term period, regardless of market conditions.

SIPs are not Flexible:

Another common myth around the SIP investment plan is that this investment instrument is less flexible for investors as compared to other instruments. There are misconceptions that the tenure of the SIP plan or the amount invested in it cannot be changed. Another misconception is that having once invested in a SIP investment, you will not be allowed to discontinue it.

None of these statements are true. An SIP is among the most flexible investment instruments available to people, and one of the easiest to customize according to your specific requirements. With an SIP, you can easily alter the amount you have invested in it, and the tenure for which you are investing. Unlike many instruments which charge you for making these changes to an existing investment, an SIP investment has no penalties for making these changes.

However, some SIP plans do have restrictions regarding the minimum amount that you can invest and the minimal amount of time that you must invest for, in order to be able to reap any rewards at all. Make sure to ask questions about this before you sign on for any particular SIP, to ensure that you understand all the important terms and conditions of your investment.

Returns are Guaranteed:

In line with the rising popularity of the instrument, several myths have come up surrounding SIPs which are seeing a lot of acclaim from across different demographic sets of the population. One common misconception has been that investing in a SIP will guarantee you returns, since your funds are invested periodically into the same nature of investment.

While no investment can ever guarantee you profitable returns, however, if you do invest in SIP, you stand a better chance of earning returns than through a more directly market-linked instrument. This is again owing to the rupee cost averaging principle, which enables you to offset the market volatility by remaining invested for a longer period of time.

Only for Equity Markets:

The dearth of knowledge in the common arena about investment instruments is evident when you realise that some of the myths are quite contradictory to each other. A common misconception around SIPs is that they invest only on equity stocks or in the market. This misconception deepens into mistrust, since the equity markets are notorious for being volatile and affected by a range of issues, including political, economical, and social, both locally and globally.

This makes several investors wary because it significantly reduces the chances of earning profitable returns. However, this is not true. The fact is that you can choose which kind of security you would like to invest in, through your SIP investment plan. Based on your goal, requirement as well as risk profile, you can take the call on which kind of security you wish to invest in and thus, have control over your funds.

Conclusion:

SIPs are useful instruments, especially for middle class salaried investors, to invest in the share market. However, before you invest in an SIP, make sure you have the minimum knowledge about both the stock market as well as the strategy of the fund managers.