Mutual Fund: Types, Return & Rule.
It has been observed that systematic investment plans or SIPs are best suited to long term creation of wealth. But there are some very critical advantages of SIPs. Here are a few.
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SIPs give the benefit of rupee cost averaging. In good times you get more value and in bad times you get more units.
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SIPs are a discipline. By default, each month on a said date you are forced to save for long term goals. This discipline makes a big difference.
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It synchronizes with your income flows. If you get salaries or commissions on a set date, you can set your SIP accordingly so you don’t feel the pinch.
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You can start as small as Rs. 500 per month and even as small investment done regularly can create big wealth in the long run.
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SIPs on equity mutual funds are a super value creator in the long run, as long as you sustain and keep reinvesting returns via growth funds.
But SIPs are not as simple as they appear to be. You need to work on these SIPs to make them work for you. Here are some golden rules to make a success of your SIP. More important is the interpretation of the rule.
| Rule 1 – Start Early | But how soon should I start the SIP? |
There is no time line but the sooner you start the better. At least, you must start as soon you start earning money on a regular basis, however small the SIP may be. Let us also understand the reason. The earlier you start, the more your principal earns returns and then the more your returns also earn returns. That is the power of compounding. Even if you save smaller amounts but consistently save in a SIP and hold for long, your returns can be fantastic. Look at the proof of the pudding.
| Particulars | Tom | Dick | Harry | Jack |
| Starts SIP at age | 25 | 30 | 35 | 40 |
| Ends SIP at age | 55 | 55 | 55 | 55 |
| SIP Tenure | 30 years | 25 years | 20 years | 15 years |
| SIP Amount | Rs.5,000 | Rs.10,000 | Rs.15,000 | Rs.20,000 |
| CAGR Yield | 15% | 15% | 15% | 15% |
| Total SIP Outlay | Rs.18 lakhs | Rs.30 lakhs | Rs.36 lakhs | Rs.36 lakhs |
| SIP Value at 55 | Rs.3.51 crore | Rs.3.28 crore | Rs.2.27 crore | Rs.1.35 crore |
| Wealth Ratio | 19.5 times | 10.9 times | 6.3 times | 3.8 times |
Let us take the case of Tom first. Tom starts earliest but also does the smallest SIP. Despite that, when he retires at 55 he has created more wealth than others who saved more. That is why saving early makes sense as it makes money work harder for the investor. Just look at Harry and Jack. Both contributed Rs.36 lakh as SIP but just because Tom started earlier, he has created more wealth despite a lower monthly SIP outlay. This makes it clear that the sooner you start, the smarter you end up.
| Rule 2 – Stay Loyal to your SIP | But, what if my SIP fund underperforms? |
Remember, the right word is not loyalty but discipline. That means; you are loyal to your goals, not to any particular fund. If the fund is consistently underperforming, think with your feet and change the fund. Now, you can change the fund, but don’t stop the SIP, which is a discipline. Hence, once you start a SIP, ensure not to discontinue the SIP or even miss on SIP contributions. When we talk of being loyal, we talk of being loyal to your goals. If the fund underperforms, by all means change the fund, but don’t change your SIP idea.
| Rule 3 – Prefer growth plans | What if I need regular income? |
There are two reasons for preferring a growth plan. Firstly, a growth plan does not pay dividends so it is an auto compounder. The returns are automatically reinvested, which is what you want in your long term goals journey. That is what SIP in a growth fund does. Secondly, any dividend income on equity funds or debt funds are taxed at peak rate. On the contrary, you pay a much lower tax when you opt for capital gains on growth funds. The idea of the SIP is to instil discipline in savings. When you need regular income at a later stage, you can rather do a systematic withdrawal plan (SWP) instead of a dividend plan.
| Rule 4 – SIP on what type of equity funds | Can I do SIP on sector funds? |
The idea of mutual funds is to diversify your risk so always prefer diversified funds. Sector funds can be too risky and when it comes to your SIPs for life goals, you cannot afford unnecessary risks. Your long term SIPs should always be in diversified funds. Most sector funds and thematic funds go through cycles and hence carry a lot of concentration risk. You basically invest in mutual funds to diversify your risk and if you opt for a sector fund or a thematic fund you go against that basic rule.
| Rule 5 – Consistency of returns | Why is consistency important |
It is like cricket. Everyone who scores in most of the innings. A batsman who scores a double century and a string of zeroes is too risky. Same applies to mutual funds too. Look for consistency quarter after quarter. Don’t just look at the final returns or CAGR returns. They don’t tell you much about interim volatility. Try and pin down on which of the funds have been consistent over time. When you choose a consistent fund, you don’t worry about timing the entry. That is very important in a SIP.
| Rule 6 – Goal tagging of SIPs | How and why should SIPs be tagged |
Remember the old wisdom, “If you do not know where you want to go, it does not matter how fast you run or how hard you work”. The same is true of SIPs too. You give direction and purpose to SIP by tagging them to goals. Tag each SIP explicitly to a long term goal. For example, you can decide that two SIPs are for retirement, one SIP is for your child’s education and another SIP is for your child’s wedding. Short term SIPs for purposes like home loan margin, car loan margin, foreign holidays can be debt fund SIPs. The core idea is to tag to goals for clarity.
| Rule 7 – Focus on post-tax returns | How much you retain, not just earn |
Don’t make the mistake of looking at SIP returns on pre-tax basis. That is not what you are going to get. Look at post tax SIP returns. Also, check if your inflation assumptions are correct and whether you overestimated return assumptions? Now let us look at the past tax part. Union Budget 2018 introduced 10% flat tax on LTCG. This is likely to substantially impact your equity SIPs in a big way. Most investors either had to increase SIP amounts or reduce targets. Post-tax evaluation of SIP can give you a lot of personal finance insights.