What Is An SIP And How Does It Work? – Forbes Advisor INDIA

Every industry once matures during its life cycle, it gains acceptance and comes up with certain practices that becomes common phenomena. Such practices get curated, discussed, debated and often adopted in several allied industries as well. The banking and lending segment within the financial services industry introduced the concept of equated monthly instalments or EMIs, which has revolutionized retail lending over the past two decades. Such is the draw for EMIs that many goods and services are no longer sold at their price, but EMI. Similarly, in the mutual fund investing space, the prominence of Systematic Investment Plan or SIP is no different. 

Over the past decade or so, SIP has become synonymous with mutual fund investing. And such is the popularity of SIPs that even seasoned investors consider it to be an investment and not a tool to invest in mutual funds. 

What is an SIP?

The simple structure of an SIP lets you invest a fixed sum in various mutual funds periodically. So, you could invest in a fund of your choice across frequencies such as monthly, quarterly, weekly, daily or any other periodicity that you are comfortable with. SIP is nothing but a smart investing tool to invest in mutual funds. A disciplined approach to investing, especially in mutual funds has several possible benefits, especially in the long run. This regular investing could become a habit, if you include mutual fund investing as part of your monthly household budget, which you manage with your regular monthly income.

What makes SIP so popular is the ease and convenience it offers, enabling small investments over the long run which has the potential to create wealth for investors. The flexibility to invest a sum as small as INR 500 a month makes SIP not just affordable, it also provides many first time mutual fund investors with the option to experience the way mutual fund investing works. The transfer of money from one’s bank account to the fund; the allotment of units based on the unit price, which is known as the net asset value (NAV) of the fund on the day the money is credited into the fund and so on.

How Does An SIP Work?

To start investing in a mutual fund through SIP, you need to be know your customer (KYC) compliant. KYC involves submission of requisite documents, which include bank account details, PAN Card and identity proof. With a valid KYC, you could invest by filling up a physical application form or online through the asset management company (AMC) or other platforms as per your convenience in the fund that you wish to invest. When selecting the SIP way to invest, you have the choice of opting for an investment frequency any date, monthly, quarterly etc. You could also select a particular date for SIP from the available options.

Having made the necessary choice, you have basically linked your bank account to the investment account which would seamlessly transfer funds from your bank account to the fund in which you have selected to invest through SIP. Supposedly you start a monthly SIP, it means that each month on a particular date, a fixed sum from your bank account is debited and credited to the fund for unit creation. The fixed sum would be converted to units in the fund based on the prevailing NAV at which the units are credited to your mutual fund investment account (See table: SIP at Work). 

As illustrated, in case of a monthly SIP of INR 10,000 every month, this instalment would create units in the mutual fund based on the NAV at which the units are allotted. For instance, when the NAV is INR 25, the number of units would be 400, and it would be 425.53 when the NAV is INR 23.50 and so on. The NAV is the reflection of the index or the market movement on which the fund is based and can go down or up depending on how the market functions.

When you examine closely, you can see that when the NAV is high (likely higher market level) the number of units allotted for the same INR 10,000 SIP is lower as compared to the month when the NAV is low (market is down). In this manner, over market cycles of lows and highs; the unit cost of your investment averages. This aspect is known as rupee cost averaging and is an important trait of investing through SIP. For instance, over a decade of monthly SIP results in 120 occurrences of opportunity in the selected fund over different market cycles and NAVs.

Rather than looking for opportunities to invest in the fund when the market is down or the NAV is low; by investing through SIPs, you could mitigate the risk of timing the market and stay invested for a longer period of time and attain target goals. By doing this, one inculcates the discipline of investing and helps money to compound and grow over the long term.

Below table (Disciplined Investing Effect) demonstrates how regular and disciplined investments through SIPs for the long term in small, regular instalments could help you create wealth. The growth could be attributed to the power of compounding. 

Compounding, here, as a concept is the reinvestment of capital gains in the funds which generates additional earnings through accumulated earnings of preceding periods.. The impact of compounding can be experienced when investing through SIPs over the long term, especially in the growth option of the mutual fund. 

When investing in the growth option of a mutual fund, all capital gains made by the fund is ploughed back into the fund. So, every time you invest through SIPs in the growth option, you have the potential to ride the overall long-term growth. As an investor, this growth can be realised only at the time of redemption of your investments.

Another way to experience the impact of compounding and long-term when investing through SIPs is to consider an SIP investment made for 10 years from age 20 to 30 years of an individual and is then left untouched for the next 30 years. In comparison another SIP investment is started from age 30 for the same sum for the next 30 years; the outcomes indicate how SIPs benefit from long-term investing (See: Staying invested for long).

In this example, assume two friends Amit and Anil invest monthly an amount of INR 5,000 in a fund that earns 12% returns. Amit invests from age 20 to 30, INR 5,000 and then stops investing further. In contrast, Anil starts a decade late with INR 5,000 and invests for the next 30 years till he turns 60. Comparing their total value of investments indicates that Amit’s cumulative amount invested of INR 6 lakh benefits from long-term investment by growing to INR 3.48 crore when he turns 60. Anil’s cumulative amount invested of INR 18 lakh over 30 years grows to INR 1.74 crore. The impact of time on your investments can be well understood from this example. 

SIPs have helped break down financial goals into achievable targets and popularised goal-based investing. Effectively, for every financial goal, based on the sum needed and the time in hand to achieve it; one could use the SIP option to invest individually for each goal and track its performance and achieve them in time (See: Goal-based SIP investing). SIPs have the power to work towards realising your financial goals that are some years to go as long as one practices regular investing in mutual funds. 

The SIP way of investing in mutual funds is convenient, easy to understand and also simple to start. The popularity of SIPs is such that in August 2021, there stood 4.32 crore active SIP accounts with monthly SIP contribution being INR 9,923 in August 2021 (Source: AMFI, Monthly Data). 

There are several variants of SIPs that exist today, but for most investors, a monthly SIP is suitable to maintain their cash flows which could be aligned to their monthly income.

Bottom Line

The simplicity of SIP and ease of understanding has the potential to ride over market cycles for disciplined investors to create long-term wealth. Given the upside to SIP investments, make a start, and invest in mutual funds through SIPs and work towards realising your financial goals.