What is SIP and its advantages

SIP and its advantages

If you have been buying mutual funds, it is very unlikely that you have not heard of systematic investment plans (SIPs). A SIP investment is like any normal mutual fund investment except that it is a regular commitment. In a SIP plan, the investors defines the periodicity (monthly, quarterly) and the date on which the SIP debit should happen. The rest is automated and over a period you will find yourself better off, with a lower cost of acquisition and a higher return on investment. That is one of the key SIP benefits.

Normally, investors rely on mutual fund SIP investments to plan for long term goals like retirement, children’s education, marriage, second home etc. It is not just about mutual fund SIP returns or SIP performance. More importantly SIP is a discipline as it forces you to commit a fixed sum each month. Since that becomes a commitment, the resultant wealth creation also becomes extremely systematic. A classic variant of SIP is the tax saving SIP, wherein the tax planning becomes a discipline than a year end affair. These expositions can go on but the best way to understand the power of a SIP is through a live example.

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How a SIP works in practice and how it builds an advantage?

One of the most important aspects in the success of SIP is time. You just worry about continuing your SIP for a long time than worry about timing the market. To understand this point, we look at 4 investors who start a similar SIP at different stages of their life.

In the above illustration while Alpha starts his SIP early and runs it for a full 30 years, Epsilon starts his SIP very late and runs the SIP for just 15 years. However, the results are quite surprising. Alpha has invested just Rs5,000 per month or a total outlay of Rs18 lakhs over 30 years, which has grown to Rs1.97 crore. However, Epsilon has invested twice the amount of Alpha, but his wealth creation is nearly half of Alpha.

A better way to interpret this data is based on the wealth ratio. For instance, despite investing the lowest sum, Alpha has the highest wealth ratio of 10.97X. On the other hand, Epsilon invested Rs36 lakhs but has a wealth ratio of just 2.94X. The difference is the time that they run the IPO. The longer you run the SIP, the longer your principal earns returns and the longer your returns earn further returns. That is the power of compounding and that has worked best in favour of Alpha as he starts early.

What are the key benefits of SIPs?

SIPs or systematic investment plans are simple and entail discipline. Here are some key advantages that SIPs bring to the table for investors in mutual funds.

1. SIPs are simple and have low entry barriers. You can do a SIP with as low as Rs500 outlay per month. If you stick to a quality fund over the long term, the empirical experience is that you end up with above-average returns. There is a wide choice of funds to do your SIP and the process for registering for the SIP is very simple. You just fill up a SIP form and the SIP is automatically activated and the investments can happen through direct debit mandates.
2. SIPs are about discipline. Asking people to save and invest is tough unless there is a product that can help them invest on regular basis. That is where SIPs fit in as they are normally on auto mode and do not require too much of manual intervention. SIPs are proof of the rule that discipline matters most in long term investing.
3. You cannot talk about SIPs and not refer to rupee cost averaging (RCA). What exactly is this concept of rupee cost averaging and how does it work? The concept of RCA means a SIP buys more units when the market is low and enhances portfolio value when markets go up. This makes the SIP an extremely useful product for volatile scenarios. Since markets are generally unpredictable, the SIP is an automatic winner.
4. SIPs best gel with financial planning. The first step to financial planning is identifying your long term and medium term goals. Then you need to figure out how to be financially prepared for such goals. That can be best executed through SIPs (ideally equity SIPs for long term goals). You just need to peg SIPs to specific goals so that you perfectly know what each SIP is meant for. It also gives a lot of clarity when it comes to monitoring these SIPs.
5. An important aspect of SIPs is that they are extremely flexible. There are a number of reasons. For instance, you can peg long term goals to equity funds, medium term goals to debt or hybrid funds and short term goals to liquid funds. There is no limit on the amount of SIP as long as you are willing to get into that discipline. You can start and stop the SIP at any point of time after giving advance notice to the fund. However, it is best not to stop a SIP in between. You can have stepped-up SIPs to factor in an increase in your income. You can also use systematic transfer plan (STP) to sweep funds from a liquid fund to an equity SIP. Also systematic withdrawal plans (SWPs) offer a tax efficient method of drawing down your retirement corpus. The moral of the story is that there is a huge flexibility that investors can get from SIPs.
6. Do SIPs do better than lump-sum? Maybe not in a bull market. However, if you go through 3-4 cycles over 15-20 years, it is more likely that SIPs would do better than lump sum investing. Over time, the rupee cost averaging works in favour of the investors by reducing costs and enhancing ROI.
7. Power of compounding can be best realized via SIPs as we have seen in our illustration. Alpha vastly outperforms Epsilon despite investing half the amount. That is because Alpha starts early and hence time works in his favour. He has given a much longer time for the returns to earn more returns. One of the caveats is that  you stick to growth plans and don’t opt for dividend (ICDW) plans.
8. Last, but not the least, SIP can double up as emergency fund to fall back upon, although that is not advisable. The idea is that SIPs are eventually mutual fund investments and are hence liquid at any point of time.

SIPs are a great idea and come with a lot of advantages. Perhaps, the discipline and the compounding power of SIPs is what makes them stand out.