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Saturday, September 3, 2011

SIP - A Boon for Small Investors

SIP works on the principle of regular investments. It is like your recurring deposit where you put in a small amount every month. It allows you to invest in a mutual fund by making smaller periodic investments (monthly or quarterly) in place of a heavy one-time investment i.e. SIP allows you to pay 10 periodic investments of Rs 500 each in place of a one-time investment of Rs 5,000 in mutual fund. Thus, you can invest in a mutual fund without altering your other financial liabilities. It is imperative to understand the concept of rupee cost averaging and the power of compounding to better appreciate the working of SIPs.

SIP has brought mutual funds within the reach of an average person as it enables even those with tight budgets to invest Rs 500 or Rs 1,000 on a regular basis in place of making a heavy, one-time investment.

While making small investments through SIP may not seem appealing at first, it enables investors to get into the habit of saving. And over the years, it can really add up and give you handsome returns. A monthly SIP of Rs 1000 at the rate of 9% would grow to Rs 6.69 lakh in 10 years, Rs 17.83 lakh in 30 years and Rs 44.20 lakh in 40 years.

Even for the cash-rich, SIPs reduces the chance of investing at the wrong time and losing their sleep over a wrong investment decision. However, the true benefit of an SIP is derived by investing at lower levels. Other benefits include:

1. Discipline

The cardinal rule of building your corpus is to stay focused, invest regularly and maintain discipline in your investing pattern. A few hundreds set aside every month will not affect your monthly disposable income. You will also find it easier to part with a few hundreds every month, rather than set aside a large sum for investing in one shot.

2. Power of compounding

Investment gurus always recommend that one must start investing early in life. One of the main reasons for doing that is the benefit of compounding. Let’s explain this with an example. Person A started investing Rs 10,000 per year at the age of 30. Person B started investing the same amount every year at the age of 35. When they attained the age of 60 respectively, A had built a corpus of Rs 12.23 lakh while person B’s corpus was only Rs 7.89 lakh. For this example, a rate of return of 8% compounded has been assumed. So the difference of Rs 50,000 in amount invested made a difference of more than Rs 4 lakh to their end-corpus. That difference is due to the effect of compounding. The longer the (compounding) period, the higher the returns.

Now, instead of investing Rs 10,000 each year, suppose A invested Rs 50,000 after every five years, starting at the age of 35. The total amount invested, thus remains the same - Rs 3 lakh. However, when he is 60, his corpus will be Rs 10.43 lakh. Again, he loses the advantage of compounding in the early years.

3. Rupee cost averaging

This is especially true for investments in equities. When you invest the same amount in a fund at regular intervals over time, you buy more units when the price is lower. Thus, you would reduce your average cost per share (or per unit) over time. This strategy is called 'rupee cost averaging'. With a sensible and long-term investment approach, rupee cost averaging can smoothen out the market's ups and downs and reduce the risks of investing in volatile markets.

People who invest through SIPs capture the lows as well as the highs of the market. In an SIP, your average cost of investing comes down since you will go through all phases of the market, bull or bear.

4. Convenience

This is a very convenient way of investing. One of the way is to just submit cheques along with the filled up enrolment form. The mutual fund will deposit the cheques on the requested date and credit the units to one’s account and will send the confirmation for the same. The most convinient option is to start SIP via your online trading account like ICICI direct, HDFC Securities, Sharekhan, India Infoline, Motilal Oswal etc. You simply select the mutual fund house and the scheme in which you want to start SIP, enter the investing amount, frequency (fortnightly, monthly or quaterly) and time period. Amount will get debited through ECS (electronic clearing service) based on the specified parameters defined by you.   

5. Other advantages

There are no entry or exit loads on SIP investments. Capital gains, wherever applicable, are taxed on a first-in, first-out basis.

Monthly investment of a fixed amount brings in discipline into your fiscal behaviour. Since the amount gets deducted from your bank account automatically, you do not even realise it. This inculcates a savings habit, forces you to save and brings in a regularity in your investment pattern and helps you in reaching financial goals in a painless manner.