What Is SIP And How Does It Work
October 09, 2019
Investments have become an integral part of financial planning. Initially it was only savings, but now the quest to earn higher returns have led to investment. SIP is one such way of investment which has been largely opted by investors.
What is SIP?
Systematic Investment Plan (SIP) is a disciplined investment approach that helps in building greater wealth for future by investing a pre-determined sum at regular intervals (weekly, monthly, quarterly, etc.) You can also choose the option of auto-debit by instructing the bank to periodically withdraw the amount and direct the investment towards your chosen mutual fund scheme.
As SIPs are flexible in nature, investors can anytime increase their investment amount and also discontinue their investment.
How SIPs work?
SIPs work like recurring investments, where this amount is auto-debited from your bank account and invested in the mutual fund of your choice. Once the amount is deposited, you get a certain number of units of the mutual fund scheme where you have invested. The number of units that you have invested depends upon the Net Asset Value (NAV) of that particular scheme for that particular day.
SIP allots you additional units of the scheme with every instalment. As the NAV of the scheme keeps on changing, with the same SIP amount you may buy fewer units when the market is high and more units when the market is low.
So, why is SIP an ideal investment option? There are two underlying processes to understand the work of SIP.
Power of compounding
Unlike simple interest where the interest is calculated on the base capital, in case of compounding, interest is calculated on the newly increased capital after the interest is added to the base capital. So in case of compounding, your money grows exponentially. For instance, if you deposit Rs 100 for a tenure of 5 years with interest of 10%, the amount in case of simple interest will be Rs 150; while in case of compound interest, it will be Rs 161. So, power of compounding gives a rise of 7%.
This amount staggeringly increases when the term increases. For instance, the same amount with the same rate of interest when is invested for 20 years, the compounded amount becomes Rs 673 while in case of simple interest, the amount becomes Rs 300.
Rupee Cost Averaging
This is another advantage of SIP in which a person buys more units when the market is low and buys fewer units when the market is high. Here is an illustration which explains rupee cost averaging; we consider two situations of investment in mutual funds one through SIP and another through lump sum.
|Month||NAV||SIP investment (Rs)||No. of units||Average cost per unit (Rs)||Lump sum investment (Rs)||No. of units||Average cost per unit (Rs)|
Over a period of 6 months, the investment through SIP gets more units i.e. 300 with per unit cost at Rs 12. Similarly, with a lump sum investment, one gets only 240 units with per unit cost as high as Rs 15.
The entire process of SIP can be beneficial only when a person starts investing early and parks the money in the market for a longer period. One can start low and increase investments in the long run to enjoy the benefits of compounding. SIP investment calculator helps you to calculate your returns on your systematic investment. Start investing in your preferred fund through SIP to fulfil your long dreamt financial goals.
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