How SIP Works?

Learn all about what is SIP and how it works?
How SIP Works?
4 mins read
8 Apr 2024

SIP stands for Systematic Investment Plan. It is a method of investing in mutual funds where you invest a fixed amount of money at regular intervals, such as monthly, quarterly, or yearly. You can choose from various mutual fund schemes that suit your risk appetite, financial goals, and time horizon. SIP allows you to start investing with a small amount and gradually build a large corpus over time. Read more to learn what is SIP, how SIP works and more in detail.

How does an SIP work?

When you start an SIP, you need to select a mutual fund scheme, an amount, and a frequency for your investment. You also need to provide your bank account details and a mandate for auto-debit. Every time you invest, you get some units of the mutual fund scheme at the prevailing net asset value (NAV).

The NAV is the price per unit of the mutual fund. As you keep investing regularly, you accumulate more units, and your investment grows. You can track the performance of your SIP online and redeem your units whenever you want, subject to the exit load and tax implications of the mutual fund scheme.

Why is SIP considered an optimal investment choice? There exist two underlying mechanisms that elucidate its functionality.

Firstly, the Power of Compounding in SIP mutual funds is a highly advantageous feature. Unlike simple interest, which bases calculations solely on the principal amount, compounding entails reinvesting earnings, resulting in exponential growth over time. For instance, investing Rs. 100 for 5 years at 10% interest yields Rs. 150 with simple interest but Rs. 161 with compounding. Over 20 years, this gap widens significantly. By initiating SIP investments early and remaining committed to them, investors can leverage compounding to amass substantial wealth for their long-term financial objectives.

Secondly, Rupee Cost Averaging is another benefit of SIP, wherein more units are purchased when the market is low and fewer units when it is high.

Month

NAV

SIP investment (Rs.)

No. of units

Average cost per unit (Rs.)

Lumpsum investment (Rs.)

No. of units

Average cost per unit (Rs.)

1

15

600

40

12

3,600

240

15

2

10

600

60

       

3

12

600

50

       

4

12

600

50

       

5

15

600

40

       

6

10

600

60

       

Total

 

3,600

300

       


Illustrated through a comparison between SIP and lump sum investments, it becomes evident that over a period of 6 months, SIP accumulates 300 units at an average cost of Rs. 12 per unit, while a lump sum investment yields only 240 units with a higher average cost of Rs. 15 per unit.

Why should you choose an SIP?

SIP has many advantages over other modes of investment. Here are some of them:

  • Simple and easy to manage: SIP is a hassle-free way of investing in mutual funds. You do not need to worry about timing the market, monitoring the NAV, or making lump sum payments. You just need to set up an SIP once and let it run automatically.
  • The power of compounding: SIP helps you to benefit from the power of compounding, which means earning returns on returns. By investing regularly and reinvesting your returns, you can multiply your wealth over time. The longer you stay invested, the higher the compounding effect.
  • Flexibility: SIP gives you the flexibility to choose the amount, frequency, and duration of your investment. You can also increase, decrease, pause, or stop your SIP anytime as per your convenience. You can also switch between different mutual fund schemes within the same fund house.
  • Rupee cost averaging: SIP helps you to reduce the average cost of your investment by buying more units when the NAV is low and fewer units when the NAV is high. This way, you can lower the impact of market fluctuations and volatility on your investment.
  • High return: SIP can help you to achieve higher returns than other fixed income instruments like bank deposits, bonds, or post office schemes. This is because mutual funds invest in various asset classes like equity, debt, gold, or hybrid, which have the potential to generate higher returns over the long term.
  • Financial discipline: SIP helps you to develop a habit of saving and investing regularly. It also helps you to align your investment with your financial goals and plan your finances better.

How can you achieve more with SIPs?

SIP is a simple and effective way of investing in mutual funds, but you can also optimise your returns by following some tips. Here are some of them:

  • Select the right mutual fund scheme: You should choose a mutual fund scheme that matches your risk profile, investment objective, and time horizon. You should also consider the past performance, fund manager’s track record, expense ratio, and exit load of the scheme. You can compare different mutual fund schemes online and read their scheme information documents before investing.
  • Select the right amount for your SIP investment: You should invest an amount that you can afford and sustain over the long term. You should also factor in your income, expenses, savings, and goals while deciding the amount. You can use an SIP calculator to estimate the future value of your investment based on the amount, frequency, and expected return.
  • Select the right frequency for your SIP: You should choose a frequency that suits your cash flow and convenience. You can opt for monthly, quarterly, or yearly SIPs depending on your income cycle and availability of funds. You can also align your SIP date with your salary date or any other date that is convenient for you.
  • Stay invested for the long term: You should invest in SIP for the long term to reap the benefits of compounding and rupee cost averaging. You should also avoid redeeming your units prematurely or frequently, as it may affect your returns and may have tax implications. You should stay invested until you achieve your financial goals or need the money for an emergency.
  • Do not put all your eggs in the same basket: You should diversify your portfolio by investing in different mutual fund schemes across different asset classes, sectors, and themes. This will help you to reduce your risk and enhance your returns. You can also use online tools like portfolio analysers and risk profilers to check your portfolio diversification and risk exposure.

When to invest in SIP in mutual funds?

Here are opportune times to commence investing in SIP in mutual funds:

  1. Commencement in early age: Embarking on SIP investments in your 20s or 30s harnesses compounding's potential for long-term wealth accumulation. With ample time on your side, you can accumulate substantial assets to meet future financial requirements efficiently.
  2. Mid-life commencement: Starting SIP in your 40s or 50s secures a comfortable retirement or fulfils financial objectives. Despite the need for more time for compounding, disciplined investing can still yield significant results, ensuring financial stability in later years.
  3. Stable income requirement: Before initiating SIP, ensure a stable income source to comfortably commit to regular contributions. Evaluate your financial situation to guarantee surplus income after meeting essential expenses, facilitating stress-free investment endeavours.
  4. Commencement at the beginning of the month: Kickstarting SIP at the month's onset fosters financial discipline and prevents procrastination in investments. By consistently investing early, you can leverage Rupee Cost Averaging, potentially lowering overall investment expenses over time.
  5. Special occasions for investment: Utilise lumpsum amounts received on special occasions like bonuses or inheritances efficiently by investing in SIP. Mark memorable events such as birthdays or anniversaries by initiating SIP, promoting meaningful wealth accumulation.

Things to keep in mind for SIPs

SIP is a smart and convenient way of investing in mutual funds, but you should also be aware of some things before you start an SIP. Here are some of them:

  • SIP is not a guarantee of high returns: SIP does not guarantee high returns or capital protection. The returns of SIP depend on the performance of the underlying mutual fund scheme, which is subject to market risks and uncertainties. You should invest in SIP only after understanding the risks and rewards of the mutual fund scheme.
  • SIP is not a one-time activity: SIP is not a one-time activity that you can set and forget. You should monitor your SIP performance regularly and review your portfolio periodically. You should also make changes in your SIP amount, frequency, or scheme as per your changing needs and goals.
  • SIP is not a substitute for financial planning: SIP is not a substitute for financial planning, but a part of it. You should have a clear financial plan that defines your goals, time horizon, risk appetite, and asset allocation. You should also have an emergency fund, insurance cover, and debt management plan in place before you start an SIP.

Conclusion

SIP is a systematic and disciplined way of investing in mutual funds that can help you to achieve your financial goals. SIP offers many benefits like simplicity, flexibility, compounding, rupee cost averaging, and high returns. However, you should also follow some tips and precautions to optimize your SIP returns and avoid common mistakes.

Calculate your expected investment returns with the help of our investment calculators

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Frequently asked questions

What is a top-up SIP?

A top-up SIP is a facility that allows you to increase your SIP amount periodically, giving you the flexibility to invest higher when you have more income or savings.

What is the power of compounding?

The power of compounding is the ability of an investment to generate earnings, not only on the principal amount, but also on the interest earned over time. This leads to exponential growth of your wealth.

What is meant by rupee-cost averaging?

Rupee-cost averaging is a strategy where you invest a fixed amount of money at regular intervals in the market, irrespective of any fluctuations in price. This helps you to buy more units when the market is low and less when the market is high, reducing your average cost per unit.

What is SIP top-up’s main benefit?

The main benefit of SIP top-up is that it helps you to reach your financial goals faster by boosting your investment value and taking advantage of the market opportunities. It also helps you to fight inflation and increase your savings rate.

How are SIPs taxed?

SIPs are taxed depending on the type of mutual fund and the holding period of the investment. Each SIP instalment is considered as a separate purchase transaction and the period of holding is calculated from that date. Equity funds are taxed at 15% for short-term capital gains (less than 12 months) and 10% for long-term capital gains (more than 12 months) more than Rs. 1 lakh.

Debt funds are taxed at the slab rate for short-term capital gains (less than 36 months) and 20% with indexation for long-term capital gains (more than 36 months).

Hybrid funds are taxed based on their equity exposure.

How does SIP work with example?

SIP, or Systematic Investment Plan, involves investing a fixed amount regularly in mutual funds. For instance, investing Rs. 5,000 monthly. This amount is used to purchase units of the chosen mutual fund at the prevailing NAV. Over time, these investments accumulate, leveraging the power of compounding for potential returns.

How does SIP give profit?

SIP generates profits through systematic investments in mutual funds over time. By consistently investing a fixed amount, investors benefit from rupee cost averaging and the power of compounding. This disciplined approach minimises the impact of market fluctuations, potentially leading to significant returns over the long term.

Can I invest Rs. 1,000 per month in SIP?

Yes, you can invest Rs. 1,000 per month in SIP. Many mutual funds offer SIP options with minimum investment amounts as low as Rs. 500 or even Rs. 1,000 per month, making it accessible to a wide range of investors with varying budgetary constraints.

What if I invest Rs. 5,000 a month in SIP for 3 years?

Investing Rs. 5,000 monthly in SIP for 3 years can potentially yield significant returns depending on the mutual fund's performance. Over this period, your investments would accumulate, benefiting from rupee cost averaging and compounding, potentially resulting in considerable growth.

How to get Rs. 50 lakh in 5 years with SIP?

Achieving Rs. 50 lakh in 5 years with SIP depends on factors like the chosen mutual fund's performance and the amount invested monthly. By selecting funds with historically strong returns and investing a sufficient amount regularly, along with leveraging the power of compounding, this goal can be pursued.

How much is it safe to invest in SIP per month?

The safety of investing in SIP per month depends on factors such as your financial goals, risk tolerance, and the selection of suitable mutual funds. Diversifying investments across different asset classes and choosing funds with a proven track record can help mitigate risks associated with SIP investments.

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