Mutual funds offer investors an option to invest in a lump sum or through SIP. What is a systematic investment plan (SIP)? It is a facility available to investors to invest in mutual funds in a disciplined manner, gradually over time. In other words, a fixed amount is invested at pre-determined intervals. SIP investment works on the principle of cost averaging over a long period and gains from compounding. Investors get habituated to save a fixed amount regularly, and that drives savings discipline.
Mutual funds are among the most common avenues to invest, given the flexibility and benefits they offer. Investors can begin with a minimal amount and do not have to open a Demat account. Transactions are straightforward, with both online and offline options being available. Above all, diversification through mutual funds is a given as the amount splits across several shares and possibly across asset classes, depending on funds’ objective. Let us discuss more about the key features and concept in greater detail.
Key features of a systematic investment plan
One of the most popular mechanisms is to invest through a systematic investment plan (SIP). An investor regularly contributes to a mutual fund in equal investments over a long period. A few essential features of a SIP are as follows:
- Regular investment of an equal amount and pre-defined intervals
- Investors with irregular cash-flows should remain careful
- Date to invest is not flexible
- Time of investment is as per the cut-off timelines
- The investment happens in the same fund, time and again at decided time points
- SIP requires a long-term commitment
- Investing regularly instils financial discipline
- Dozens of investment options available
- Across asset classes (E.g., equities, debt, gold, real estate, foreign fund of funds, etc.)
- Within each asset class (E.g., in the equities asset class, there is an option to invest into large-cap equities, mid-cap, small-cap, or a combination of large & mid-cap, etc.)
- Investments are highly liquid, with no lock-in period in general (except for tax saving funds, ELSS, etc.)
How does the SIP work – the concept of cost averaging
On the pre-determined dates, you invest a fixed amount into the mutual fund scheme. After that, a certain number of mutual fund units get allocated to you at every purchase, corresponding to investment value. Net Asset Value (NAV) of the scheme helps determine the number of units issued to you.
Net asset value (NAV) represents the per unit market value of a mutual fund.
NAV = Total value of all the cash and securities minus the liabilities divided by total shares outstanding as of the date.
The way it works, investors do not have to time the market, nor is there an opportunity to do so. In other words, investment happens on specific dates irrespective of the market trend.
If the broader market is bullish (going up), you purchase fewer units with every consecutive investment. On the other hand, you get more units during a bearish market (going down) for the same investment amount.
Throughout the investment duration, units get accumulated, each having a different cost attached to it. Eventually, and over time, the purchase cost usually turns out to be on the lower side vs the market value at the time of redemption. This concept is called the cost averaging mechanism.
There are several pieces of research done on what is the optimal investment horizon. Most indicate that strategies with a long-term horizon are better rewarding. One can classify a continuous investment for 5-7 years or more as long-term in nature.
Advantages of a systematic investment plan
Investors can get started with SIP and earn relatively better returns in the long run. SIP is a convenient way of invest in a mutual fund.
While the most significant advantage of SIPs is cost averaging, there is more to it. Here is a list of other notable benefits:
Power of compounding generates higher returns
Compounding occurs when you generate income from the income that you earned from the original investment. The process creates a sequence, wherein income gets reinvested and generates more income until an asset exists.
Continuous reinvesting leads to significant improvement in returns over time. Therefore, SIPs generate grander returns using the power of compounding.
Highly convenient to invest in SIPs
Collecting information about top-performing funds, top-ranked funds, etc., is very easy and convenient. In other words, good amount of research is available and accessible freely across many platforms. All this information immensely helps investors to select a suitable mutual fund.
The next step is to make the actual investment, and the same is possible both online and offline.
- Online investment – to purchase mutual funds directly from your bank account through net banking. In other words, you can invest through a broker website or via a third-party website (e.g., moneycontrol.com)
- An offline investment where the investor can avail services of agents to purchase the desired funds. Alternatively, investors can visit the nearest branch of an asset management company and initiate the purchase
Regular investing promotes financial discipline
SIPs work on the principle of ‘Save First and Spend Next’ and brings in financial discipline. Therefore, the investment happens in parts and over time, so there is no need to allocate sizeable financial resources.
The dates on which the amount gets debited are fixed and does not provide any choice to investors. The lack of flexibility ensures investors have saved money for SIPs.
A fixed investment rhythm often pushes people to be vigilant about their cash flows. Especially the one’s with fluctuating inflows must maintain financial disciple and manage funds to meet SIP commitments.
Limited financial acumen with some guidance is sufficient
First-time investors find mutual funds as an effortless way to participate in the capital markets. Therefore, to begin the investing journey through a SIP is pretty straightforward.
One can easily invest a portion of income in mutual funds schemes by initiating a SIP. Limited research or a quick connection with a financial advisor can help novice investors find 2-4 good mutual fund schemes. And this is a decent start point.
As you select the mutual fund, consider these criteria:
- End objective of investment – whether you want to achieve a target or make an investment in general
- Risk tolerance – every investment avenues comes with a risk. The level of risk you wish to take will help you decide which asset class is suitable for investment
- Asset under management (AUM) – although there is no correlation between the size of AUM and fund returns, but going with funds with a meagre AUM size can be risky
- Based on your liabilities and financial background, you can decide the investment duration
- Reputation of a fund house is an essential factor while choosing a scheme to invest
No need to time the market or find securities
SIP investment happens on the pre-determined date. Therefore, and by design, the process relieves you of any stress to time the market.
Transaction happens at the cut-off time, and investors cannot influence the timing of investing. In other words, investments happens based on the mutual fund’s objective. Investors do not select stocks, and there is no scope for a personal bias.
There is no possibility to react impulsively during volatile markets (ups and downs). Through the SIP route, the rule of thumb to keep emotions away while making investment decisions naturally comes to life.
Possible to own a fraction of shares
Investing through SIPs (mutual fund) makes it possible for investors to own security partly. The number of units instead represent the ownership in a mutual fund. Part ownership of shares is not possible through direct investing. Above all, to own the same securities held via a mutual fund, an investor will require a significantly large sum.
What is preferred – SIP or a lump sum investment?
SIP spreads the investible sum into equal instalments over time, whereas lump sum is a one-time investment. Investment mechanism bears significant impact on the returns, and therefore due consideration is vital.
Generally speaking, SIP is a preferred way of investment for various reasons:
- Averages cost of ownership
- Good option for novice investors
- Less stressful during volatile market conditions
- Inculcates financial discipline
- Allows market participation even with a small investible surplus
Both methods are suitable, and the investor can choose either of the two. Factors like market understanding, financial stability, goals, investment horizon, and risk tolerance will help determine the best path.
Read more about the comparison between SIP and One-time investment here.
Tax planning with SIPs
Equity Linked Savings Scheme (ELSS) offers income tax benefits. An investment into ELSS is deductible from taxable income under section 80C of India’s Income Tax Act. The maximum possible deduction is Rs1.5 Lakhs in a financial year under this section, which covers investment options like PPF, NSC, etc.
ELSS invests most of their corpus into equity & equity-related instruments. Investment into ELSS comes with a mandatory lock-in period of three years from the date of purchase. There is, of course, no outer limit. However, it is not possible to withdrawal prematurely during the lock-in period.
ELSS schemes have a relatively shorter lock-in period in the tax-saving investment options. Therefore, these investments are well suited for salaried individuals as the principal amount is deductible from taxable income.
Read more at Equity Linked Savings Scheme here.
Investing in any form is better than not investing at all. SIP is a recommended form of investing, given the advantages attached.
About the author
The author is a senior finance professional with over fifteen years of work experience in corporate finance. He has an affinity for matters relating to personal finance and investment management. Through his writing, the author wants to share his knowledge and understanding of the subject.
The author has used his knowledge, experience, and understanding of the subject and has exercised extreme care and caution to avoid any possible mistakes. However, the author does not take any responsibility for any error that exists.
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