How Does SIP Works?
Systematic Investment Plan (SIP) offers a convenient method for investing in mutual funds, allowing you to determine your desired regular investment amount easily. This amount is automatically deducted from your bank account to buy mutual fund units. Over time, these investments grow due to compounding. There are two principles on which the SIP works. They are:
1. Power of Compounding
2. Rupee Cost Averaging
Power of Compounding
The power of compounding in Systematic Investment Plan (SIP) refers to reinvesting the returns generated by your mutual fund investments back into the same fund. Over time, this process leads to exponential growth as your returns earn additional returns.
The longer you stay invested, the more significant the compounding effect becomes, potentially resulting in substantial wealth accumulation, making SIP an effective strategy for long-term financial goals.
Let’s consider two friends, Alice and Bob:
Alice started investing ₹1,000 monthly in an SIP at 25, with an expected SIP return rate of 10% per annum. Over 30 years, she has made a total contribution of ₹360,000.
On the other hand, Bob started his investments at the age of 35 and invested ₹1,000 monthly, expecting a 10% annual return. Over 20 years, Bob’s total investment amounted to ₹2,40,000.
Now, let’s examine the difference:
At 55, Alice’s investment has grown to approximately ₹22,79,000 due to the power of compounding.
Meanwhile, Bob invested for only 20 years and accumulated approximately ₹7,65,697.
Disclaimer : Data shared is for illustration purposes only actual numbers can vary.
Rupee Cost Averaging
Investors regularly contribute fixed amounts to mutual funds through SIP, fostering financial discipline. Rupee Cost Averaging, an underlying principle, mitigates market volatility’s impact by ensuring more units are purchased when prices are low and fewer when prices are high.
For instance, if an investor invests Rs. 10,000 monthly in a fund with an initial NAV of Rs. 50, they’ll buy 200 units. If the NAV drops to Rs. 40 the next month, the same Rs. 10,000 fetches 250 units. Conversely, if the NAV rises to Rs. 60 in the third month, it buys approximately 166.67 units.
Over three months, the investor accumulated 616.67 units, averaging the cost to around Rs. 15.34 per unit. This systematic approach not only smoothens investment costs but also potentially enhances returns over time, showcasing the efficacy of SIP coupled with Rupee Cost Averaging.