How do SIPs work and how to make the most of them?

An SIP in an equity mutual fund is one of the best ways to create wealth in the long run.

 An equity mutual fund SIP is one of the best ways to create wealth in the long run. The very name SIP is suggestive. It implies that by saving small amounts over a longer period of time, you can substantially grow your wealth. For example, you can decide to invest a small sum, say, ₹5,000 per month on a specific date for the next 20 years. The returns at the end of this tenure can be very surprising. Here is how!

We all know about the power of compounding. The longer you stay invested, the longer your principal earns returns and the longer these returns earn returns. Hence, to get the most out of SIPs, you must start early. What about market volatility? That is where rupee-cost averaging comes in. 

What is rupee-cost averaging, you ask?

Let us explain!

When you spread your monthly SIP over a longer period, say, 20 years, your investment is distributed over 240 months. When markets are up you get more value and when markets are down you get more units. This is referred to as rupee-cost averaging. The table below captures how this simple investment tool works wonders in the long run.

Indicative growth of SIP values over multiple investment periods

In the above example, Monica saves four times what Amit saves per month. At the age of 55, Monica has contributed twice of what Amit has contributed. Yet, Amit achieves higher wealth creation because rupee-cost averaging worked in his favour over a longer time frame.

Discipline matters more than timing in SIPs

Often, investors tend to worry too much about whether their SIP date should be 10th, 15th or 25th. In reality, the date hardly matters as long you can stay disciplined and invest in the SIP in a sustained manner. 

Once you start the SIP, ensure that you do not discontinue nor miss out SIP contributions. 

Secondly, the dividend plan option is not as beneficial as the growth option. In the former, a dividend is paid out of the annual profits, whereas in the latter, the profits are reinvested. Given that the objective is to create wealth over the long term, it advisable to opt for the growth option.

SIPs should be on equity funds, ideally diversified funds

While it’s possible to set up SIPs in several types of funds, not every type delivers similar returns. For instance, liquid funds deliver returns of 5.5–6% per year on average. So an SIP on liquid funds, will fetch you about 4% after tax deduction. 

Thus, it would take you 18 years to double your capital. Clearly, this is not the best way to create wealth. The answer lies in equity funds. Ideally, long-term SIPs should be in diversified equity funds. You can invest in multiple mutual funds to spread your risk.

Meaningful SIPs are those tagged to long-term goals

Before starting with SIPs, write down your goals. Think of how much you will need for your retirement, for your daughter’s education, etc. To make your SIP purposeful, tag each SIP to a long-term goal. For example, few SIPs can be tagged to your retirement goal while others can be tagged for your child’s education. This will help you monitor whether or not you are on target with respect to your long-term goals.

To sum it all up, mutual fund SIPs are a kind of passive approach to wealth creation. You don’t have to worry about timing the market or about monitoring it too much. As long as you are consistent, the rupee-cost averaging and the power of equities will help you create wealth in the long term.

Disclaimer: Investments in mutual funds are subject to market risk, please read all the related documents before investing.

The above article is purely academic in nature and aims to provide knowledge about basic mutual fund concepts. It should not be construed as an opinion or investment advice.