At a time when fear of volatility is holding back many investors from stock market, at a time when it’s certainly not the best of times for venturing into new investment and at a time when good returns is elusive, there is still one way to ride out the market mayhem — Systematic Investment Plan or SIP.
Many of you must be aware of SIP’s investment strategy but the faith of many gets shaken when markets start the downward move. As a knee-jerk reaction, many investors cash out of the market by discontinuing their SIPs, falsely assuming SIP is of no use during meltdown.
But is it the right approach? Simply, no because the relevance of SIP still holds good during times of volatility.
Let’s dig deeper into the concept called SIP and see why exactly it is an excellent investment tool without being too heavy on the pockets of the investor. The concept of SIP revolves around two very basic but effective principles:
Rupee-Cost Averaging
Since the investment is staggered and spread across the entire investment tenure at regular intervals, the cost of purchase of mutual fund units is averaged. The basic premise behind SIP is that during the entire investment horizon the markets may go up down several times but since the investor keeps buying at all levels the net investment cost is average of all the purchases. (See How Rupee-Cost…)
If, on the other hand, one thought markets are crashing in January and stopped his SIP, then his return would have been only Rs 2998.9 (263.07×11.40) as against original investment of Rs 3000 for three months.
On the other hand, if one had continued SIP for the full 12 months, his return on investment of Rs 12,000 would be Rs 12,370.13 (1150.71×10.75), a modest gain in one year time. The long and short of it is that if the average NAV is lower then the closing NAV (which is the case with SIP) the investor would be in profit. On the other hand, if the average NAV is higher than the closing NAV (which happens when SIP is discontinued) he investor would be at a loss.
SIP, by virtue of rupee-cost averaging principle, tides over most of the volatility of the market and hence is supposed to be held strongly even when markets are looking down the barrel. In fact, the principle of rupee-cost averaging works wonders when markets are volatile. As and when markets are down, one gets higher number of units for the same investment and when markets go up it adds to the appreciation in value of investment. Higher the units accumulated, higher the value which can be assumed at the end of tenure.
Power of Compounding
The power of compounding is visible in case of long term investment and thus it is important for one to start early. The sooner one starts, the higher the amount one can get. This can be best understood with a small example, A invests Rs 1000 per month for 20 years while B invests Rs 2000 for a period of 10 years; so both would be investing a total of Rs 2,40,000. Assuming the market grows at 15% for either of them, the investment value of A would be 15 lakh, while that of B would be 5.5 lakh. Just because A started early, the power of compounding helped him to have earned higher than B.
Apart from the functional aspect of SIP, another most important advantage and feature of SIP is that it brings discipline to investment habits of an investor.
SIP can be used as a retirement tool to build sizeable corpus. If a person aged 25 and starting his/her career can start investing Rs 1000 per month for next 35 years and if market grows at an average of 15%, he/she can build a corpus of 1.50 crore. SIP is very effective in long term but even middle aged people can use this to plan for retirement, of course the investment amount increases considerably.
Long Term Investment
SIP is a long term investment tool and if one stays put for long term, it can generate good returns. However, one of the common trends observed when markets are going down is that investors tend to pull out their money which is surprising. If markets are looking down the barrel and if a fund’s NAV is in a free fall, it may be a matter of worry for lump sum investors who can either switch to a safer liquid fund or even redeem.
However, as far as SIP is concerned, it works well in these conditions. Falling NAV can only add more and more units for the same amount. And when markets tend to look northwards and NAV’s improve, investor will add value to their investments.
SIP by nature ought to be a long term investment. Long-term can range anywhere from 5 years to 35 years depending on the age when one starts investing. Five years is generally considered as minimum tenure for SIP for simple reason that a normal economic cycle lasts for five years. Thus, the entire market’s ups and downs can be captured in one investment tenure.