What is SIP? How does it work?

If you want to buy a car five years from now and need a fund of 7-8 lakhs, then opt for SIP to accumulate the funds for the purchase.  If you plan to shift to a bigger house after 10 years and need to accumulate funds, then you should opt for SIP. If you have not saved any money for retirement in 30 years from now, then you should opt for SIP. Well, what kind of investment is SIP that has an answer to every financial need? Is SIP a scheme? How much money can be invested in it? How do returns work? Let’s find out.

First, let’s understand what SIP is?

SIP stands for Systematic Investment Plan. It’s not a specific investment scheme but rather a way to invest in mutual funds. Your money is invested in mutual funds through SIP. Now, as the name suggests, it’s systematic, meaning regular, investment plan. Put these three terms together, SIP means a systematic way of investing.

This is the most popular way of investing in mutual funds, and the biggest advantage of investing in this way is that even those with lower incomes can invest in mutual funds through SIP, as you can start with just 500 rupees per month.

Now, let’s understand how this works. You decide to save 500 rupees every month and invest it. Every month, on a fixed date, this amount will be deducted from your account and invested in the mutual fund scheme.

Let’s see this through an SIP calculator. Suppose Rahul starts a SIP of 500 rupees per month in an equity mutual fund from 1st January 2024. He will invest for 10 years, assuming an estimated annual return of 12%. In 10 years, Rahul’s invested amount will be 60,000 rupees. He will receive a return of 56,170 rupees, and thus Rahul will accumulate 1.16 lakhs.

The power of compounding works for the investor in SIP, meaning the return earned on the investment is reinvested. The next return is earned on the new principal amount. In this way, you can accumulate a good amount over a long period. SIP helps you earn interest on interest.

Let’s understand this with some numbers. Investing 500 rupees every month means investing 6,000 rupees in the first year. After adding the return, the total becomes 6,404 rupees. Next year, another 6,000 rupees are invested, totaling 12,000 rupees. On this, a return of 1,217 rupees is earned at 12%, but this return is added to the previous principal amount, so it becomes 12,404 rupees. On this, the return is calculated, and this process continues, benefiting from compounding.

Apart from compounding, SIP averages your investment cost, thus protecting you from market fluctuations. While there are various types of mutual funds like equity, debt, and hybrid funds, if you want to invest for a long time, equity funds are better suited because when you invest in equity funds through SIP for a long time, the risk of market volatility decreases.

Look at how Rahul’s SIP faces the ups and downs of the market in one year. If the unit price is 23 rupees in the first month, he will get 21.74 units for 500 rupees. If the unit price falls to 21 rupees in the next month, Rahul’s account will be credited with 23.81 units. Between the ups and downs of NAV in a year, with 6,000 rupees, Rahul can buy 301 units, which will be valued at 7,215 rupees, and the average unit price will be 20.33 rupees. On the other hand, if Rahul invests a lump sum of 6,000 rupees in mutual funds at 23 rupees per unit, he will get 260 units, and the value after a year will be 6,261 rupees. In the long run, fewer units are bought at high prices while more units are bought at low prices during downturns. Thus, when calculating the average in the long run, the impact of market fluctuation is reduced.

So, start an SIP, even if it is a small amount and accumulate a large corpus by investing regularly for a long time.