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Systematic Investment Plans and their Benefits May 20, 2011
Systematic Investment Plans (SIPs) offer great benefits to mutual fund investors. We explore the reasons for this and what you must do before investing into an SIP.
Author : iFAST Research


Untitled Document

If you remember the childhood story of the Tortoise and the Hare, then the Systematic Investment Plan (SIP) is equivalent of the tortoise in the race to create wealth.  Systematic Investment Plans or SIPs as they are commonly known, offer  benefits while making sure that you continue moving slowly but surely to win the race in money matters.

What is an SIP?

SIP, also known as Regular Savings Plan (RSP) in some countries, allows you to invest a fixed amount at pre defined frequencies in mutual funds. A bank / post office recurring deposit is the only other investment option that is similar to SIP. There are basically two options that an investor could take when they are making investments, one would be to invest lump sum into mutual funds and the other would be to invest using an SIP. The following are some of the benefits associated with investing in an SIP:

1)     SIP enforces investing discipline

Many people have burnt their fingers and in some case even their “hands” by investing at will and on rumours.  SIPs take away the risk from both investing at will and on rumors. As SIPs require you to invest periodically and continuously and over time, SIPs make periodic investing more of a habit. By regularly investing you tend to be more focused on achieving your financial goals. This brings in investing discipline.

2)     No need to time the markets

Everyone in the market wants to buy low and sell high. This is known as timing the market.  But, the only catch is we don’t know when to buy and when to sell.  Timing the market is risky and time consuming process as

i)              One has to do research to identify which stocks are undervalued and invest in them.

ii)             Even after investing in the stock, one is not guaranteed of the returns.

Table 1: An example of a fund’s NAV movement
  Price (Rs / Unit)
January 10.00
February 11.40
March 9.00
April 10.30
May 9.50
June 8.90
July 10.80
August 11.90
September 8.50
October 9.80
November 11.70
December 8.30
Source: iFAST Compilations

Table 1 shows an example of a fund’s NAV movement. If you believed in timing the market, then in September you would have bought each unit for Rs.8.5 and in November you would have sold at Rs. 11.70. This sounds easy in hindsight but the bigger issue would be, when you bought into the stock in September:

a)     You are not sure when will it go up

b)    You are not sure when to sell it

With SIP, the need to time the markets is taken away due to the concept of Rupee Cost Averaging.

3)     Rupee Cost Averaging (RCA)

Rupee Cost Averaging (usually known as Dollar Cost Averaging) is an investment strategy widely used by investors all over the world. This calls for you to invest a fixed amount of money regularly (on a monthly, quarterly or yearly basis) in a disciplined manner. The main benefit of Rupee Cost Averaging is that it takes the guesswork out of investing and thereby the need to time the markets. A lot of stress is avoided as you do not have to decide whether the fund is expensive or not and whether the market condition is suitable to invest. Table 2 shows an example of how more units are acquired when prices are low and vice versa assuming that you invest Rs. 1000 every month.

Table 2: Units acquired every month for Rs.1000 invested through SIP

 

Monthly Investment Amount (Rs.)

Price (Rs / Unit)

Units Acquired

January 1000 10.00 100.00
February 1000 11.40 87.72
March 1000 9.00 111.11
April 1000 10.30 97.09
May 1000 9.50 105.26
June 1000 8.90 112.36
July 1000 10.80 92.59
August 1000 11.90 84.03
September 1000 8.50 117.65
October 1000 9.80 102.04
November 1000 11.70 85.47
December 1000 8.30 120.48
Total 12,000 - 1215.8
Source: iFAST Compilations
Since the amount is fixed, the number of units that you can subscribe to in a particular fund varies. If the price of the fund increases, you would naturally be able to subscribe to a lesser number of units. You would buy more units during market slumps and fewer units during market up-turns.

Table 2 shows an example of RCA. If you had Rs.12,000 to invest, you could choose to invest all of your money (lump sum) or invest Rs. 1,000 every month (SIP). If you chose to invest a lump sum of Rs.12,000 in January, you would have 1,200 units. The cost per unit is Rs. 10. On the other hand, if you invest through an SIP, you would have 1,215.8 units by the end of December. The cost per unit is Rs.9.87, and hence, the potential loss is lessened. From the above example, the return when investing  a lump sum is -17%, the return of the SIP is -15.9%. One might contend that the period we illustrated in the examples looked like a good period to do Rupee Cost Averaging. However, how about during other time periods? Would it still make sense to do Rupee Cost Averaging?

Rupee Cost Averaging Works When Markets Are Moving Nowhere!

Let us look at another example of how a better return can be achieved by using the Rupee Cost Averaging strategy, under different market scenarios.

From the three scenarios shown in Chart 1, the total investment amount for each of the scenarios is Rs.12,000, for both investment strategies. From the table, we found that the Rupee Cost Averaging strategy gave a better return in scenarios 2 and 3. This is especially noticeable in scenario 2, where there is a 4.8% gain by using Rupee Cost Averaging, while there is no capital gain from using lump sum investing. This is because there were a larger number of units subscribed from July to November (compared to the lump sum subscription price).


Hence, the average cost of units is less than Rs.10 (unit price at the beginning). Generally, if the market is going down during the period one is invested; better performance will be achieved using the Rupee Cost Averaging strategy, versus the lump sum investing method. In fact, since no one can know exactly what will happen next, you may still earn a good return in scenario 1 – going through a sustained uptrend for a prolonged period of time.

There are three major benefits of using Rupee Cost Averaging. First, it helps decrease your loss if the unit price drops below your initial price, as the average unit cost is lowered by using Rupee Cost Averaging. Second, there is no need to do market timing. Third, the initial investment outlay is lower compared with lump sum investing.

 The Rupee Cost Averaging strategy is useful for investors who have a long investment time horizon (10 years or more).



Table 3: Returns of different markets scenario
  Final Value Profit/Loss
  Rupee Cost Averaging Lump Sum Investing Rupee Cost Averaging Lump Sum Investing
Scenario 1 Rs. 18,421 Rs. 24,000 53.5% 100.0%
Scenario 2 Rs.12,571 Rs. 12,000 4.8% 0.0%
Scenario 3 Rs. 6,641 Rs. 6,000 -44.7% -50.0%
Chart 1: Three different market scenarios
Scenario1
Source: iFast compilations

4)     No entry or exit loads

Certain fund houses have schemes that waive off entry and exit loads, if invested through SIPs. Please note though, that the decision to waive off entry and exit loads is that of the mutual fund house and may be limited to certain schemes only. Waiving off loads for SIPs is not an industry practice.

5)     Very low monthly investments

Most SIP schemes require you to put in very low amounts. The amounts can be as low as Rs. 500 to Rs. 1000 per month and some schemes have even lowered the bar by requiring you to pay Rs. 100 only per month. This way, you can do regular investments and never feel a pinch in your pocket.

6)     Taxes

SIPs are taxed for capital gains on first in first out basis. Consider the values in table 1; suppose you sold 300 units in February of the next year. Short term capital gains will be only levied on the number of units bought in February, March and April and not on the units bought in January. Gains from the units bought in January will be considered for long term capital gains and not for short term capital gains.

Some of the points you might want to think through before starting an SIP:

1)     Decide on the monthly investment amount that you can sustain over the investment period. For example, it can be Rs.1000, Rs. 2,000, Rs. 5,000 or any amount that you are comfortable with.

2)     Select the funds in which you want to invest through SIP, but make sure that the portfolio is diversified.  For example, you can invest Rs.500 in 10 mutual funds or Rs.1000 in 5 funds if you had chosen Rs. 5000 as the sustainable monthly investments in the previous point.  

3)     Understand the entry and exit loads applicable for SIPs. Some schemes have no entry / exit loads for SIPs over certain period. So, if you withdraw funds within the specified period, you might be charged the entry and exit loads. Or some funds require you to keep the funds with the mutual fund for a certain period and in case you withdraw within the period, the mutual fund house may charge you only exit loads.

 

iFAST and/or its content and research team’s licensed representatives may own or have positions in the mutual funds of any of the Asset Management Company mentioned or referred to in the article, and may from time to time add or dispose of, or be materially interested in any such. This article is not to be construed as an offer or solicitation for the subscription, purchase or sale of any mutual fund. No investment decision should be taken without first viewing a mutual fund's offer document/scheme additional information/scheme information document. Any advice herein is made on a general basis and does not take into account the specific investment objectives of the specific person or group of persons. Investors should seek for professional investment, tax, and legal advice before making an investment or any other decision. Past performance and any forecast is not necessarily indicative of the future or likely performance of the mutual fund. The value of mutual funds and the income from them may fall as well as rise. Opinions expressed herein are subject to change without notice. Please read our disclaimer in the website.

 


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