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SIP - a simple way to wealth creation

My article in Mid-day Gujarat, Mumbai edition today:

http://epaper.gujaratimidday.com//epaperpdf/gmd/20102014/20102014-md-gm-23.pdf

The English translation is as under:

Convenience is the middle name of mutual funds – one may not be exaggerating by saying this. The convenience that mutual funds provide, has been highlighted in many discussions. This ensures that mutual funds become an integral part of any individual’s personal financial plan.

Let us look at the various conveniences. The first and foremost is the combination of very high transparency and easy liquidity – we had written about this in one of our earlier articles.

Another feature of mutual fund as a product is the unitisation of the investment. The money invested into a fund is converted into small units of the fund. In fact, an investor can also hold fractions of the unit. This allows an investor to invest (or withdraw) any amount of money – large or small (subject to a small minimum limit) depending on one’s needs. This facility makes investing in a mutual fund similar to operating a bank account.

Over the years, as the product has matured, the investment advisors have packaged some of these features and devised some excellent investment strategies. These packages then help an investor match the cash flow with the investment account. Let us look at one such strategy: systematic investment plan (SIP).

Systematic investing is a simple form of investing on a regular basis. For most investors the regular cash flows are on a monthly basis – be it salary or various household expenses. In that case, the net cash flow, or the difference between income and expenses, or the savings also happen on a monthly basis. Hence, there is a clear need to have a solution to park this monthly saving somewhere. This is where mutual funds offer a systematic investment plan. An investor has to fill up one form and submit the same with multiple payment instruments (or instruction to one’s bank for multiple investments). Then the mutual fund company takes over the entire administrative part of the process, i.e. handling the payment instruments, custody of the same, deposition in bank, sending information of transaction to the investor, etc. The investor has to only ensure sufficient balance in the bank account. While an SIP can be done in any mutual fund, it offers certain distinct advantages when done in an equity fund.

Equity as an asset class has two characteristics: one, in short periods of time, the prices of equity products fluctuate a lot; and two, over long periods of time, equity has the potential to create wealth by giving excess returns over inflation and taxes. SIP takes the advantage of both these characteristics of equity and works on two principles: the power of compounding and rupee cost averaging.

When one invests a fixed sum every month, one is able to turn the volatility of stock markets to one’s advantage. Let us see how it works. An investor is able to save a sum of Rs. 3,000 every month and decides to enter into a systematic investment plan in an equity fund (let us assume there are no loads – we will discuss about loads later). As equity prices fluctuate, the NAV of the units of the equity fund will also fluctuate. However, since the number of units purchased would be inversely proportional to the NAV (or the price of purchase), every time the NAV is high, the investor would buy fewer units and when the NAV is low, the investor would buy more units. This will lower the average cost of buying the units.

Thus, systematic investing offers a direct benefit of matching an investor’s requirement of managing monthly savings while also provides additional benefits of the power of compounding and rupee cost averaging. In this way, SIP works best to help an investor create wealth.

Many also do an SIP in liquid funds, which allows one to accumulate money in a slow and steady manner to build a reserve fund. While this does not offer the benefit of “Rupee cost averaging” discussed earlier, it serves a definite purpose of accumulation by saving small amounts regularly.

Amit Trivedi

The author runs Karmayog Knowledge Academy. The views expressed are his personal opinions.

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